Duties and Responsibilities of Directors Section 5000.1

Duties and Responsibilities of Directors Effective date November 1995 Section 5000.1

INTRODUCTION are elected and have qualified. No state member bank is to have less than five or more than Directors are placed in a position of trust by the 25 directors as specified in section 31 of the bank’s shareholders, and both statutes and com- Banking Act of 1933. Various laws govern the mon law place responsibility for the affairs of a election, number, qualifications, oath, liability, bank firmly and squarely on the board of direc- and removal of directors and officers, as well as tors. The board of directors of a bank should the disclosure requirements for their outside delegate the day-to-day routine of conducting business interests. Other laws pertain to certain the bank’s business to its officers and employ- restrictions, prohibitions, and penalties for secu- ees, but the board cannot delegate its respon- rities dealers serving as directors, officers, or sibility for the consequences of unsound or employees; director interlocks; purchases of imprudent policies and practices, whether they assets from, or sales to, directors; commissions involve lending, investing, protecting against and gifts for procuring loans; embezzlement; internal fraud, or any other banking activity. The abstraction; willful misapplication; false entries; board of directors is responsible to the bank’s political contributions; and other matters. The depositors, other creditors, and shareholders for examiner must be familiar with these laws and safeguarding their interests through the lawful, the related regulations and interpretations. informed, efficient, and able administration of the institution. In the exercise of their duties, directors are governed by federal and state banking, securities, and antitrust statutes, as well as by common law, which imposes a DIRECTOR INDEPENDENCE liability on directors of all corporations. Direc- tors who fail to discharge their duties com- Directors must exercise their independent pletely or who are negligent in protecting the judgment when managing the bank’s affairs. A interests of depositors or shareholders may be responsible board will not merely rubber-stamp subject to removal from office, criminal pros- management’s recommendations, but will review ecution, civil money penalties imposed by bank them carefully before deciding whether they are regulators, and civil liability. Title IX of the in the bank’s best interests. A board that is Financial Institutions Reform, Recovery, and excessively influenced by management, a single Enforcement Act of 1989 and the Comprehen- director, or a shareholder, or any combination sive Thrift and Bank Fraud Prosecution and thereof, may not be fulfilling its responsibilities Taxpayer Recovery Act of 1990 greatly en- to depositors, other creditors, and sharehold- hanced the enforcement powers of the federal ers. Diversification of the board of directors is bank regulatory agencies, including the Federal important and can be accomplished by including Reserve Board. Section 5040 of this manual, directors with no ownership or family-ownership ‘‘Formal Corrective Actions,’’ describes those interest in the bank and who are not employed enforcement powers in greater detail. by the bank. A bank’s board of directors may include one or more advisory directors. Advisory directors generally do not vote but may provide additional information or advice to the voting directors. An DIRECTOR SELECTION advisory director who functions in that capacity is generally not subject to the same regulatory The affairs of each state member bank are requirements as voting members and has less overseen by its board of directors. The initial liability for the board’s actions. However, if an directors are elected by the shareholders at a advisory director exercises a degree of influence meeting held before the bank is authorized to or control over the board or the bank that is not commence business. Thereafter, they are elected commensurate with that status, it is appropriate at meetings held at least annually on a day for examiners to subject that individual to the specified in the bank’s bylaws. The directors same standards as voting directors. Such a hold office for a stated tenure, generally ranging person might also be subject to the same liability from one to three years, or until their successors standards as a voting director.

Commercial Bank Examination Manual November 1995 Page 1 5000.1 Duties and Responsibilities of Directors

DIRECTORS’ RESPONSIBILITIES soundness of the bank. If negligence is involved, a director may be personally liable. The respon- Directors play a critical role in overseeing the sibility of directors to supervise the bank’s affairs of the bank. Directors should understand affairs may not be delegated to the active exec- that if they neglect to carry out their fiduciary utive officers or anyone else. Directors may duties and responsibilities, they may be finan- delegate to executive officers certain authority, cially liable if the bank fails or experiences loss. but not the primary responsibility of ensuring An examiner sometimes has to remind bank that the bank is operated in a sound and legal directors of the extent of their duties and respon- manner. sibilities. Unless bank directors realize the importance of their positions and act accordingly, they are failing to discharge their obliga- Adoption and Adherence to Sound tions to the shareholders, depositors, other credi- Policies and Objectives tors, and the community. The directors’ role is to provide a clear framework of objectives and policies within which the Selection of Competent Executive chief executive officer can operate and administer the bank’s affairs. This framework is often Officers accomplished through the use of strategic plans and budgets. The strategic plan would discuss One of the board’s most important duties is to long-term, and in some cases, short-term goals select and appoint executive officers who are and objectives as well as how progress toward qualified to administer the bank’s affairs effec- their achievement will be measured. The objectively and soundly. The board is also responsible tives and policies should cover all areas of the for removing officers who do not meet reason- bank’s operations. The board of directors is able standards of honesty, competency, execu- responsible for establishing the policies that tive ability, and efficiency. The responsibility for govern and guide the day-to-day operations of selecting executive officers also entails retaining the bank, so they should review and approve them and ensuring that competent successors them from time to time. These policies are can be promoted or hired to fill unanticipated primarily intended to ensure that the risks under- voids. The board is responsible for evaluating taken by the banks are prudent and are being the performance of the chief executive officer properly managed. This means that the board of and approving the CEO’s compensation. In directors must, as a group, have a fundamental many banks, the board also approves compen- understanding of the various types of risks sation for other executive officers. associated with different aspects of the banking A state member bank that has been chartered business, for example, credit risk, foreign- or undergone a change of control within the last exchange risk, or interest-rate risk, and define two years, that is not in compliance with the the types of risks the bank will undertake. Some minimum capital adequacy guidelines or regu- of the more important areas in which policies lations of the Board, or that is in an otherwise and objectives must be established include troubled condition must provide 30 days’ writ- investments, loans, asset and liability manage- ten notice to its regulating Reserve Bank before ment, profit planning and budgeting, capital it can add a director, promote an internal staff planning, and personnel. Directors are also member to senior executive officer, or employ a responsible for adopting policies and procedures new senior executive officer. required by law or regulation, such as real estate lending policies, a security program, an interbank liabilities policy, and a Bank Secrecy Act Effective Supervision of Bank Affairs program. The examination of these policies is covered in other sections of this manual. The type and degree of supervision required of a bank’s board of directors to ensure a bank is soundly managed involve reasonable business Avoidance of Self-Serving Practices judgment and competence and sufficient time to become informed about the bank’s affairs. A bank’s directors bear a greater than normal Directors ultimately are responsible for the responsibility for upholding safe and sound

November 1995 Commercial Bank Examination Manual Page 2 Duties and Responsibilities of Directors 5000.1 practices in dealing with transactions involving in the development, maintenance, and use of other members of the directorate and their MIS throughout the institution. related interests. Directors’ decisions must pre- MIS is used by all levels of bank staff to clude the possibility of partiality or favored monitor various aspects of bank operations, up treatment. Unwarranted loans to a bank’s direc- to and including its overall risk-management tors or their interests can be a serious safety- process. Therefore, MIS should be supportive of and-soundness concern for the bank. Directors the institution’s longer term strategic goals and who become financially dependent on their bank objectives. At the other extreme, these everyday normally lose their usefulness as directors. Other financial accounting systems also are used to self-serving practices the examiner should watch ensure that basic control is maintained over for are— financial recordkeeping activities. Since numer- ous decisions are based on MIS reports, appro- • gratuities paid to directors to obtain their priate control procedures must be set up to approval of financing arrangements or the use ensure that information is correct and relevant. of particular services, • the use of bank funds by directors, officers, or shareholders to obtain loans or transact other Audits business (Directors should be especially critical of correspondent bank balances when In May 1993, pursuant to requirements of the officers, directors, or shareholders are borrow- Federal Deposit Insurance Corporation Improve- ing from the depository bank. The Department ment Act of 1991 (FDICIA), the FDIC issued of Justice’s position is that certain interbank rules and guidelines that require all banks with deposits connected with a loan to officers, total assets in excess of $500 million to have directors, or shareholders of the depositing annual audits by an independent public accoun- bank might constitute a misapplication of tant. Copies of these audit reports are to be sent funds in violation of 18 USC 656), and to the FDIC and the appropriate Federal Reserve • transactions involving conflicts of interest Bank. Furthermore, the Federal Reserve encour- (When board decisions involve a potential ages banks with assets of $500 million or less to conflict of interest, the director with the provide for annual audits by independent public potential conflict should fully disclose the accountants. nature of the conflict and abstain from voting The board or a committee designated by the on the matter. The abstention should be board should review the audit reports with the recorded in the minutes. The examiner should bank’s management and the independent public also be aware that ethical conflicts of interest accountants. The review should include— can arise when a director or director-related firm performs professional services for the • the scope of services required by the audit, bank. For example, a director who is also the significant accounting policies, and audit bank’s legal counsel may not, in some situa- conclusions regarding significant accounting tions, be able to advise or represent the bank estimates; objectively.). • the adequacy of internal controls, and actions necessary to ensure the resolution of any problems or deficiencies; and • the institution’s compliance with applicable Awareness of the Bank’s Financial laws and regulations. Condition and Management Policies Many states have laws requiring directors’ Management Information Systems examinations of the bank. When the directors lack adequate knowledge of examination tech- A management information system (MIS) pro- niques and procedures, they are encouraged to vides the information, often originated from an employ a qualified accountant or other specialist institution’s mainframe and microcomputers, to conduct all or part of this examination. The necessary to manage an organization effectively. examining committee or the entire board should MIS should have clearly defined guidelines, play an active role. Directors should obtain a policies, practices, standards, and procedures for clear understanding of the scope of the proce- the organization. These should be incorporated dures to be employed, and the final report of the

Commercial Bank Examination Manual November 1995 Page 3 5000.1 Duties and Responsibilities of Directors directors’ examination should be reviewed by nonaccrual loans, charged-off or recovered loans, the board of directors. large new loans, and loans to insiders. Directors Further guidance on the use of audit reports should also review and approve all policies and the reliance placed upon the work of exter- annually, and review and approve all insurance nal and internal auditors in the examination policies as they are obtained or renewed. They process can be found in the ‘‘Internal and should also review audit and examination re- External Audit Section’’ of this manual. ports and initiate action to correct any deficiencies noted, review correspondence with regulatory agencies, review pending litigation, and Maintenance of Reasonable keep informed of any major prospective under- takings, such as mergers, acquisitions, or new Capitalization branches or construction. A board of directors has the responsibility for maintaining its bank on a sufficiently capitalized basis. Capital planning and capital adequacy are Minutes of Board Meetings discussed in the manual section ‘‘Assessment of Capital Adequacy,’’ and the examiner should be The board should ensure that an accurate, familiar with this information. adequate record of its actions is maintained. Such a record is usually kept in the form of minutes of the board meetings. The minutes Compliance with Banking Laws and should document the board’s review of all regular items mentioned above as well as the Regulations review and discussion of all significant items that are not part of the regular meeting. Addi- Directors must carefully observe that banking tionally, at a minimum, the minutes should laws are not violated; they may be personally record the attendance or absence of each direc- liable for losses arising out of illegal actions. In tor at each meeting, detail the establishment and addition, civil money penalties can be assessed composition of any committees, and note the for unsafe and unsound actions that do not abstention of any director from any vote. Exam- necessarily involve a violation of a banking law. iners should review the minutes of board meetings, as well as a sample package prepared for a board meeting, to determine that directors Guarantee of a Beneficial Influence are receiving adequate information to make on the Community’s Economy informed, sound decisions. Meetings conducted by telephone, if allowable under state law, One reason for approving a newly chartered should be documented as thoroughly as regular bank for Federal Reserve membership is to meet meetings. a specific community need. Directors, therefore, have a continuing responsibility to provide those banking services which meet the legitimate credit and other needs of the community being BOARD COMMITTEES served. Directors should be certain that the bank Many boards elect to delegate some of their attempts to satisfy all legitimate credit needs of workload to committees. The extent and nature the community. of the bank’s activities and the relative expertise of each board member play key roles in the board’s determination of which committees to BOARD MEETINGS establish, who sits on them, and how much authority they have. Thus, there is no ideal The board should conduct its business in meet- committee structure. However, committees fre- ings held as required by the bank’s bylaws or quently found in state member banks include the state law. Regular meetings of the board should following: review statements showing the bank’s financial condition and earnings; the investment port- • Executive Committee—may be empowered to folio; and loan activity, including past-due and act when the full board is unable to meet, for

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example, between regular meetings. An minimum standards used for minutes of meet- executive committee is usually found in large ings of the full board. institutions, where it relieves the full board of the burden of reviewing the details of financial statements and operational activities. • Audit Committee—typically monitors compli- COMPLIANCE WITH FORMAL ance with bank policies and procedures, and AND INFORMAL reviews internal and external audit reports ADMINISTRATIVE ACTIONS and bank examination reports. Because it is responsible for ensuring compliance, accu- Bank directors must ensure that management racy, and integrity throughout the organiza- corrects deficiencies found in the bank. Instruc- tion, the audit committee should consist only tions to do so may come from the Federal of outside directors. The audit committee may Reserve as a formal or informal administra- supervise the bank’s internal auditor and his tive action, depending on the severity of the or her staff directly by hiring personnel, eval- problem. uating their performance, and setting their Formal actions, which include cease-and- compensation. desist orders and written agreements, are nor- • Loan Committee—may be established to moni- mally exercised when banks have serious prob- tor underwriting standards and loan quality, lems. For less serious problems, the Federal and to ensure that lending policies and proce- Reserve issues informal actions such as a dures are adequate. In most banks with loan ‘‘memorandum of understanding.’’ Informal committees, all new loans are reviewed by the actions are an agreement between the Reserve loan committee either before or after funding, Bank and the bank that sets forth the required with the threshold for prior approval being the corrective actions. The Reserve Banks are gen- amount of either the loan or the aggregate debt erally responsible for monitoring compliance to the borrower. The loan committee may also with both types of administrative actions. To be responsible for the loan review function assist in that process, the Reserve Bank nor- and for maintaining an adequate reserve for mally receives and evaluates periodic progress loan losses. reports from the bank. In addition, information • Investment or Asset-Liability Management is provided by the examiner who checks the Committee—monitors the bank’s investment bank’s compliance with the action. The Reserve policies, procedures, and holdings portfolio to Banks may initiate additional supervisory action ensure that goals for diversification, credit against the bank or individuals associated with it quality, profitability, liquidity, community when compliance is insufficient. Or, if the bank’s investment, pledging requirements, and regu- compliance with the action is satisfactory, the latory compliance are met. In some banks Reserve Banks may recommend modifying or whose complexity warrants it, asset-liability terminating the enforcement action. management committees have been estab- Examiners should briefly discuss compliance lished to replace or supplement investment with any enforcement actions on the Examina- committees. An asset-liability management tion Conclusions and Comments page and direct committee monitors the bank’s balance sheet the board of directors’ attention to the Compli- and external forces, notably interest rates, to ance with Enforcement Actions page of the help coordinate asset acquisition and funding examination report. The type and date of the sources. action or resolutions and parties to the action • Other Committees—depending on the nature should be listed. In addition, the examiner should and complexity of the bank’s business, the generally list each provision requiring action by board may establish other committees to moni- the bank and provide a comment addressing tor such areas as trust, branching, new facili- compliance with that provision. The examiner ties construction, personnel/human resources, should comment on how the bank accomplished electronic data processing, and consumer compliance or the problems that have prevented compliance. compliance. While certain information might be better discussed in the confidential section of Minutes of all major actions taken by com- the report, it is appropriate to make all salient mittees that play a significant role in managing negative comments on the Compliance with the bank should be kept and meet the same Enforcement Actions page to ensure that the

Commercial Bank Examination Manual November 1995 Page 5 5000.1 Duties and Responsibilities of Directors directors are made aware of any deficiencies ever, do not generally apply to the following and/or exceptions that may exist. organizations and their subsidiaries: The Reserve Bank may recommend termination or modification of a formal administrative • a depository institution that does not do busi- action whenever it determines that such re- ness in the United States except as an incident straints have satisfactorily served their purpose to its activities outside the United States; and should be removed or modified. In these • an Edge or agreement corporation; cases, the Reserve Bank will send a memoran- • a depository organization in formal liquida- dum with the appropriate explanation to the tion or a similar type situation; Board’s Division of Banking Supervision and • a credit union being served by a management Regulation (BS&R) for review and evaluation. official of another credit union; BS&R and the Board’s Legal Division, when • a state-chartered savings and loan guaranty appropriate, will prepare the documents neces- corporation; or sary to terminate or modify the existing admin- • a Federal Home Loan Bank or other bank istrative action. organized solely for the purpose of serving depository institutions or solely for the purpose of providing securities clearing services and related services related to other depository institutions. DEPOSITORY INSTITUTION MANAGEMENT INTERLOCKS In addition, five other exceptions are permit- ACT ted, with Federal Reserve Board approval, based on the public benefit that is derived from the Under the Depository Institution Management interlocking relationship and on the competitive Interlocks Act (Interlocks Act) as implemented nature of the institutions involved. These excep- by Regulation L, interlocking relationships of tions are for— management officials of various nonaffiliated depository institutions are prohibited, depending • institutions located in low-income areas or on the asset size and geographical proximity of controlled or managed by members of a mi- the organizations. The enforcement of the inter- nority group or by women, lock provisions of the Interlocks Act encom- • newly chartered institutions, passes full cease-and-desist powers. • institutions facing conditions endangering The intent of the Interlocks Act is to foster safety and soundness, competition among various depository institu- • institutions sponsoring a credit union, and tions by prohibiting interlocking relationships of • institutions affected by loss of management management officials. The prohibitions, how- officials due to changes in circumstances.

November 1995 Commercial Bank Examination Manual Page 6 Duties and Responsibilities of Directors Examination Objectives Effective date November 1995 Section 5000.2

1. To determine whether the board of direc- has developed adequate objectives and tors fully understands its duties and policies. responsibilities. 4. To determine the existence of any conﬂicts of 2. To determine if the board of directors is interest or self-dealing. discharging its responsibilities in an appro- 5. To determine compliance with laws and priate manner. regulations. 3. To determine whether the board of directors

Commercial Bank Examination Manual November 1995 Page 1 Duties and Responsibilites of Directors Examination Procedures Effective date November 2003 Section 5000.3

1. Update the following and review for possi- and list the areas of operation covered by ble violations of law— the reports. a. A list of directors to include— b. Distribute copies of the reports to the • home address (If the director was examiners in other areas, and request appointed or elected since the previous that they determine if reports furnished examination, state the number of years to the board are prepared accurately, residing at present address.), contain sufficient detail to allow the • date of birth, directors to make an intelligent decision, • years as a director of the bank, and are submitted on a timely basis. • approximate net worth, c. Prepare a list of areas not reporting or of • occupation, reports the board does not receive that • citizenship, are considered necessary to maintain • common stock ownership (beneficial, adequate supervision. As guidelines, con- direct, and indirect), and sider the following reports: • bonuses, fees, etc. • A monthly statement of condition or b. A list of embezzlements, defalcations, balance sheet and a monthly statement misappropriations, mysterious disappear- of income. Those statements should be ances, or thefts that have occurred since in reasonable detail and should be the last examination. That list should be compared with the prior month, with signed by the chief executive officer or the same month of a prior year, and the auditor. with the budget. The directors should receive explanations for all large c. A list of management officials (as defined variances. in the Depository Institution Manage- ment Interlocks Act) of the bank, its • Monthly statements of changes in all holding company, and holding company capital and reserve accounts. Such affiliates who are management officials statements should explain any changes. of other depository institutions. • Investment reports that group the secu- d. A list of the indebtedness of directors, rities by classifications; that reflect the executives officers, and principal share- book value, fair market value, and holders to the bank examined and any yield; and that include a summary of other bank, along with a statement of the purchases and sales. terms and conditions of each extension • Loan reports that list significant past- of credit. due loans, trends in delinquencies, rate 2. Obtain or update a listing of all areas of reductions, non-income-producing the bank’s operations that are administered loans, and large new loans granted under the provisions of written objectives since the last report. and policies that have been developed by or • Audit and examination reports. Defi- with the approval of the board. Inform the ciencies in these reports should pro- examiners assigned to review those depart- duce a prompt and efficient response ments that a policy has been developed or from the board. The reports reviewed an update has occurred. and actions taken should be reflected 3. Analyze the listing obtained in step 2, and in minutes of the board of directors note any area of banking activity for which meetings. policies should be developed. • A full report of all new executive- 4. Determine that the board has accepted its officer borrowing at any bank. responsibility to effectively supervise the • A monthly listing of type and amount affairs of the bank and to be informed of the of borrowing by the bank. bank’s condition by performing the • An annual presentation of bank insur- following: ance coverage. a. Obtain a complete set of the latest reports • All correspondence addressed to the furnished to directors at the last meeting, board of directors from the Federal

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Reserve and any other source. their related interests to the appropriate • A monthly analysis of the bank’s examining personnel to ascertain the liquidity position. extent of loans to or transactions with • An annual projection of the bank’s insiders and their interests (Those exam- capital needs. iners should be alert for any relationships • A listing of any new litigation and a with insiders’ interests that are not status report on existing litigation and included on the list.); potential exposure. f. requesting that the appropriate examin- • A thorough report on any major bank ers determine if any transactions with endeavor that each bank director is insiders are on terms more favorable expected to make a decision on, includ- than those offered to other customers (If ing branch applications and major so, determine whether the board has building plans. approved such transactions.); g. determining that directors have reviewed d. Determine the mechanism used to assign their correspondent bank accounts in responsibility for correcting deficiencies relation to possible conflicts of interest noted in regulatory reports, internal audit arising from directors’,officers’, or share- reports, external audit reports, or any holders’ borrowing from depository other reports to the board, and determine banks; and the board’s system of determining com- h. correlating all information on insider pliance with such recommendations. transactions, and preparing appropriate e. Determine how directors perform a report comments. director’s examination, the frequency of 6. Obtain the minutes of the meetings of the such examinations, and what part the board of directors, the charter, the bylaws, directors take in the process. and the minutes of shareholders meetings. f. Review the bank’s method of ensuring a. Review and summarize the bylaws and continued or resumed operations in the charter of the organization, including event of a disaster. Complete the any specific provisions on the require- emergency preparedness measures ments of directors. The resulting mate- questionnaire for inclusion in the rial should become a permanent workpapers. part of the workpapers and should be g. Review correspondence between the Fed- updated at subsequent examinations. eral Reserve and the bank to determine b. Read and summarize the minutes of all that it has been properly reported. meetings of the board since the last 5. Determine evidence of conflicts of interest examination, making certain to— and self-dealing by— • list any actions taken in contravention a. obtaining and summarizing information of the bylaws; on the business interests of directors, • record major actions taken by the board executive officers, and principal share- that are not a part of a normal monthly holders; meeting; b. comparing that information to develop a • record any resolution or discussion list of directors who have business inter- covering the development of or entrance ests in common; into a new area, such as a geographic c. analyzing the interests of directors to area, customer service, asset category, determine if the board consists of a or liability category; variety of individuals; • record the creation of any special com- d. obtaining from the examiner assigned to mittee and the area with which it is assessment of capital adequacy a list of designed to deal; shareholders who own or control, either • determine that actions taken by stand- directly or indirectly, 5 percent or more ing committees are reviewed and rati- of any class of voting security; fied by the full board; e. distributing a list of the insiders (direc- • if the minutes specify any transactions tors, officers, and shareholders whose with directors or their interests, deter- ownership of voting securities in the mine that the abstention of any interinstitution is more than 10 percent) and ested director from voting on the mat-

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ters is noted; having more than one-half of the eligible • if the minutes do not mention any shareholders represented. director-related transactions that have h. Review any stock option or stock pur- been uncovered during the examina- chase plan adopted since the preceding tion, inquire if the interested director examination, and review such action did refrain from voting. for compliance with the various condi- c. Read and summarize the minutes of the tions involving charter and shareholder board’s annual organization meeting approval. and— i. Determine if any candidate was nomi- • list standing committees and their nated for director, other than the slate members, nominated by bank management, and • have examiners who are examining review for compliance with the appropri- areas that have standing-committee ate state statute. supervision read and summarize the 7. Determine that the directors have accepted minutes of those committees, and their responsibility for selecting competent • prepare a list of major areas of opera- officers by— tion that are not monitored by specific a. determining that the board or a commit- committees. tee thereof reviews, at least annually, the d. Read and summarize the minutes of any chief executive officer’s performance in stockholders meetings. The summary attaining or progressing toward attaining should include a list of directors elected specific objectives or goals set by the at the annual meeting, the number of board, shares present and voted, individuals b. determining if a policy statement on acting as proxies, and specific action personnel exists, and ascertaining what approved by shareholders. provisions the board has made for suc- e. Ascertain during the review of sharehold- cessor management, ers meeting minutes that (1) sharehold- c. determining if any management con- ers’ approval has been received; (2) the tracts exist and, if one does, obtaining a bank’s charter has been amended, if copy, summarizing the pertinent points, necessary; and (3) compliance with and determining the reasonableness of appropriate state or federal statutes has terms, been met for the following: d. determining by inquiry how the remu- • any establishment of or change of a neration of executive officers is set and branch location who makes decisions concerning execu- • any issuance of preferred stock tive salaries, and • any increase in capital stock, either e. listing any titled individual who, by action through sale or a stock dividend of the board, is specifically excluded • any reduction in capital stock (and from being an executive officer. ascertain whether the resultant capital 8. Determine compliance with laws and regu- is not below what is required by the lations by— capital adequacy guidelines) a. reviewing workpapers of other examina- • any stock split tion areas or discussing compliance with • any bank pension plan established since other examiners to determine any viola- the preceding examination tions of laws or regulations concerning • any bank involvement in a conversion, directors that were disclosed in these merger, or consolidation examination areas, • all other matters subject to vote b. reviewing the nature and extent of vio- f. Determine the date of the annual share- lations discovered at prior examinations holders meeting and if it was in compli- to determine if similar violations have ance with the bylaws. occurred at this examination, and g. Review the charter and/or bylaws for c. correlating information obtained from quorum requirements of shareholder the minutes of board meetings to the meetings. Ascertain that, at any meeting, reports of officer borrowings that have the quorum requirements were satisfied been prepared at and forwarded from according to recorded requirements or by other banks to determine that all such

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borrowings have been reported to the reason of insufficient stock ownership board. (12 USC 72)? 9. Determine compliance with the Foreign c. Are any directors noncitizens of the Corrupt Practices Act (15 USC 78dd-1 and United States (12 USC 72)? If so, has the -2) by— citizenship requirement been waived? a. reviewing the bank’s policy prohibiting d. Do more than one-third of the directors improper or illegal payments, bribes, fail to reside in the state, territory, or kickbacks, etc., to any foreign govern- district in which the bank is located, or ment official or other person or organi- within 100 miles of the bank’s head zation covered by the law; office (12 USC 72)? b. determining how that policy has been e. Did more than one-third of the directors communicated to officers, employees, or fail to reside in the state, territory or agents of the bank; district in which the bank is located, or c. reviewing any investigation or study done within 100 miles of the bank’s head by, or on behalf of, the board of directors office, for one year before election on the bank’s policies and operations (12 USC 72)? concerning the advance of funds in pos- f. Are any transactions with directors or sible violation of the act; their related interests on more favorable d. reviewing the work done by the exam- terms than those offered to other custom- iner assigned to internal control to deter- ers (Regulation O (12 CFR 215))? mine whether internal or external audi- g. Do the deposit accounts of directors tors have established routines to discover receive greater interest than those of improper or illegal payments; other customers (section 22(e), Federal e. analyzing the general level of internal Reserve Act (12 USC 376))? control to determine whether there is h. Have any provisions of a cease-and- sufficient protection against the inaccu- desist agreement or order been violated rate recording of improper or illegal (Rules of Practice for Hearings (12 CFR payments on the bank’s books; 263))? f. requesting that examiners working in i. Has any director, officer, or employee other areas of the bank be alert for any been convicted of a crime involving a transactions that might violate the provi- breach of trust or act of dishonesty (sec- sions of the act; tion 8(g) of the Federal Deposit Insur- g. compiling any information discovered ance Act (12 USC 1829))? If so, has the throughout the examination on possible FDIC approved his or her membership violations; and on the board or employment? h. performing procedures on suspected j. Have any tie-ins of services been autho- criminal violations as outlined in section rized by the board (Regulation Y (12 5020.3, ‘‘Overall Conclusions Regarding CFR 225.7))? Condition of the Bank: Examination k. Were any loans to bank examiners dis- Procedures.’’ closed (Criminal Code—18 USC 212 10. Answer the following questions. (This ques- and 213)? tionnaire is intended to be a quick review l. Has the bank made any political contri- for determining that all laws and regulations butions (Federal Election Campaign Act pertaining to directors have been complied (12 USC 441b))? with. Questions should be answered ‘‘no’’ m. Have any employees been found to have and sub-questions should be answered misappropriated funds, made false ‘‘yes.’’ Any deviation from this pattern entries, or otherwise defrauded the bank indicates a violation or potential violation. (18 USC 656)? Situations that are not judged to be viola- n.Hasanofficer of the bank failed to make tions require comments stating the basis for appropriate written reports when an that judgment.) embezzlement, misapplication, or simi- a. Is the number of directors less than 5 or lar transaction occurred (SR-579)? greater than 25 (section 31, Banking Act o. Have any extortionate extensions of credit of June 16, 1933)? been discovered (18 USC 892–894)? b. Have any directors failed to qualify by p. Have any checks been certified against

November 2003 Commercial Bank Examination Manual Page 4 Duties and Responsibilities of Directors: Examination Procedures 5000.3

uncollected funds (18 USC 1004)? institution holding company with assets q. Have unauthorized obligations of the of $1.5 billion or less? bank been issued (18 USC 1005 and v. Have any loans to executive officers 1006)? been uncovered that were not reported to r. Has there been a change in control (Regu- the board (Regulation O (12 CFR 215) lation Y (12 CFR 225.41–225.43))? If and 12 USC 503)? so, was the Federal Reserve notified and w. Has a majority of the board failed to was the application approved? preapprove extensions of credit to any of s. Have any purchase-money loans been the bank’s executive officers, directors, made that are secured by 25 percent or or principal shareholders and their related more of the stock of another secured interests when the total loans to the bank (Regulation Y (12 CFR 225.41))? individual exceed the amount prescribed If so, have the appropriate authorities in Regulation O? been notified? x. Has the bank notified executive officers t. Has the bank failed to maintain records and principal shareholders of their report- of directors, executive officers, and prin- ing requirements (Regulation O (12 CFR cipal shareholders and their related inter- 215))? ests (Regulation O (12 CFR 215.8))? 11. Determine compliance with administrative u. Are management officials of the bank, actions by— or its holding company or holding com- a. reviewing provisions of the document pany affiliates, also management officials and of an unaffiliated depository institution b. reviewing bank records and perform- or depository holding company (Regula- ing necessary procedures to isolate tion L (12 CFR 212))? If so— noncompliance. • was such relationship established prior 12. Evaluate the bank’s compliance with formal to November 10, 1978, and previously or informal administrative actions and pre- permitted by section 8, Clayton Anti- pare comments for page one of the exami- Trust Act (15 USC 19)? nation report (SR-02-17 and SR-92-21). • was prior approval of the Federal (See also section 5040.1.) Reserve obtained for a relationship 13. Determine compliance with conditions that was developed since Novem- imposed in the approvals of corporate fil- ber 10, 1978? ings for— • does the interlocking relationship meet a. branches and relocation applications, the criteria of one of the exceptions including— permitted by Regulation L (12 CFR • capital plans or capital injections, 212)? •fixed-asset limitations, and • is the management relationship with an • CRA plans; institution whose— b. subordinated debt, operating subsidi- — principal offices or branches, aries, and interim bank applications, excluding electronic terminals, are including— located in a different RMSA from • capital plans and the bank’s or its holding compa- • prior review and appropriate clearance ny’soffices or branches (does not of disclosures. apply if either institution has assets 14. On the basis of the information obtained by of less than $20 million) (12 CFR performing the foregoing procedures, or 212.3(b))? any other procedures deemed appropriate, — principal offices or branches, evaluate the adequacy and effectiveness of excluding electronic terminals, are the board of directors. The evaluation should located in another city, town, or include, but is not limited to— village not contiguous or adjacent a. the frequency and effectiveness of and 10 miles or more apart? meetings; • if the bank or its holding company has b. the effectiveness of board committees; assets exceeding $2.5 billion, does the c. the directors’ role in establishing policy; interlocking management relationship d. the adequacy of the policies and major exist with a nonaffiliated depository inconsistencies therein;

Commercial Bank Examination Manual November 2003 Page 5 5000.3 Duties and Responsibilities of Directors: Examination Procedures

e. the quality of reports for directors, not- overall financial condition of the bank); ing any deficiencies in information flows and from operating management; h. the board’s responsiveness to recommen- f. violations of laws and regulations; dations from the auditors and supervi- g. whether any one person or group appears sory authorities. to control or dominate the board (if so, 15. Update the workpapers with any informa- comment on any adverse effects on tion that will facilitate future examinations. operating policies, procedures, or the

November 2003 Commercial Bank Examination Manual Page 6 Management Assessment Effective date March 1984 Section 5010.1

The purpose of this section is to guide the ments, both in dividends and increased market examiner in evaluating bank management. value of their stock. No bank is completely free Although the directorate is an integral part of the from the pressure of competition and, for most overall management of a bank, the management institutions, this is one of the strongest forces appraisal examination program is concerned felt. In the midst of those pressures, the clear primarily with the active officers. A review of mandate to bank management is to ‘‘perform.’’ the quality of director guidance and supervision Performance is measured in terms of long-run is covered in ‘‘Duties and Responsibilities of profitability, liquidity and solvency. It is almost Directors.’’ impossible for a bank to achieve those long- It is the responsibility of directors to employ range goals unless careful planning and coordi- a competent chief executive officer. Thereafter, nation bring efficiency to its activities. Manage- senior management normally assumes the respon- ment must recognize the bank’s position in the sibility to employ, maintain and educate a qual- market and make plans which will achieve the ified staff. Since a direct relationship exists objectives set for the institution by the directors. between the overall condition of a bank and the It must be constantly alert to the need for quality of management, the first priority in continually upgrading and expanding services evaluating the condition of the bank is to make and facilities to support and encourage the an accurate appraisal of the competency of the bank’s growth. management team. Both the directors and senior management Management is responsible, not only for the have important roles in a bank’s program of operations of the bank and the quality of its internal control and internal audit. Although assets on a day-to-day basis, but also for plan- directors have overall audit responsibility and ning for the future. Senior management should should require that the auditor report directly to be evaluated on its plans for maintaining or them, senior management normally is charged improving the condition of the bank in the future with the duty of maintaining a strong system of as well as on the bank’s present condition. The internal control. depth of planning and a general forward looking The entire examination procedure, as outlined attitude of executive officers should be consid- throughout this manual, is designed to provide a ered when projecting future management impact. clear picture of both the present and anticipated This should include an evaluation of manage- future condition of the bank under examination. ment’s efforts to provide for succession of As a result, the reports and workpapers gener- senior bank officials. ated by the examination process will serve as a The projection of future management impact major tool for examiners in their evaluation of involves an appraisal of the quality and quantity management. Examination procedures for vari- of senior and middle management. This assess- ous balance sheet accounts and departmental ment of course must be relative to the size and areas are designed to effect a comprehensive community circumstances of the bank. Examin- evaluation of internal control and internal ers must not restrict their appraisals to the past and/or external audit, and will provide the ex- and present. The past and present certainly are aminer with insight into the degree of compli- significant, requiring an in-depth analysis of ance with the bank’s own written policies in financial condition, earnings and capital ade- such areas. Similarly, the examination pro- quacy, both on an absolute basis and as a trend, cedures in ‘‘Loan Portfolio Management,’’ but, the determination of what the management ‘‘Investment Securities,’’ ‘‘Funds Manage- will do for the bank in the future is most ment,’’ ‘‘Assessment of Capital Adequacy,’’ and significant. The System’s goal is to prevent ‘‘Analytical Review and Income and Expense’’ problems from developing rather than waiting are designed to lead to a detailed analysis of for future examinations to identify deteriorating written objectives, policies and procedures in conditions. those management areas. Bank management receives strong pressure The examiner must take a practical approach from customers, stockholders and competitors. to evaluating these features depending on the Customers demand more for their money, in the bank’s characteristics. The examiner can have form of both interest and services, and stock- greater confidence in the continuity of top and holders demand higher returns on their invest- middle management when it is known that the

Commercial Bank Examination Manual March 1994 Page 1 5010.1 Management Assessment bank has an inflow of new personnel at various staff. The examiner must evaluate those areas to levels and that training procedures and advance- determine the quality of overall management. ment policies will keep the organization viable Some features of good personnel management and dynamic. are: The examiner must be concerned with salary levels within the bank and must review infor- • An organizational structure. mation collected during the examination about • Detailed position descriptions. the bank’s employee benefits program. Salaries • Carefully planned recruiting. paid and benefits provided should be compared • Appropriate training. with those offered by an appropriate peer group, • Performance review. and inquiry should be made to determine the relationship between the bank’s payroll struc- • Salary administration. ture and that offered by competitors for the same • Provision for communication. caliber personnel. The examiner must judge the appropriateness The examiner should identify and interpret of asset distribution in view of the bank’s trends that can reveal flaws in policy either as sources of funds. The examiner must evaluate written or as practiced. The examiner should the adequacy of the bank’s capital position and question the quality of management in any area expectations in view of asset quality and plans in which he or she finds serious shortcomings or for growth and expansion. The overall manage- makes significant criticisms. ment evaluation should be made by the examiner- The examiner should be alert for situations in in-charge, because he or she is in the best which top management dominates the board or position to identify weaknesses and inconsisten- where top management acts solely at the direc- cies in policies. Although examiners-in-charge tion of either the board or a dominant influence will rely heavily upon the information received on the board. Although it is extremely important from assisting examining personnel in various for the directors to assume their appropriate role areas under review, it is their task to assemble in setting objectives and formulating policy all of such information into a composite picture consistent with their responsibilities to the of the quality of management. depositors, shareholders and regulators, dia- Senior management is responsible for the logue with top management must occur. In quality of all bank personnel and for planning its banks where both directors and senior manage- own replacement. A bank’s recruiting, training, ment recognize and assume their appropriate and personnel development activities are vital to duties and responsibilities, areas for conflict are the development and continuity of a quality greatly reduced.

March 1994 Commercial Bank Examination Manual Page 2 Management Assessment Examination Objectives Effective date March 1984 Section 5010.2

1. To determine the consistency of written 5. To evaluate management experience and objectives, policies, and procedures in the depth. various asset, liability, and operational areas. 6. To determine that management has estab- 2. To determine that policies are being adhered lished systems which facilitate efﬁcient to throughout the system. operation and communication. 3. To determine that management plans 7. To evaluate the propriety and soundness of adequately for future conditions and management decisions. developments. 8. To project the impact of management on the 4. To evaluate the adequacy of the bank’s future condition of the bank. personnel practices as they relate to management continuity.

Commercial Bank Examination Manual March 1994 Page 1 Management Assessment Examination Procedures Effective date March 1984 Section 5010.3

In the following procedural steps examiners 6. Review the bank’s marketing plan for spe- should attempt to utilize already developed cific programs being planned and general material from internal or external audit sources. applicability to the institution. Also, the examining resources and circum- 7. Review the bank’s schedule of salaries and stances of the bank must be weighed in perspec- make comparisons with similar informative to set the depth of scope for this area. tion from an appropriate peer group. If deemed appropriate, compare salaries paid 1. Obtain the following, if available: and benefits received in the bank to those of a. Organization chart. other institutions with which it competes b. Management plan. directly. Determine whether the bank is c. Administrative and personal manuals. paying salaries or bonuses to inactive offi- d. Marketing plan. cers or directors and, if so, determine that e. Resumes for all executive officers and such payments have been disclosed to department or division heads which shareholders. have not been obtained in previous 8. Determine whether any executive incentive examinations. compensation plans (performance bonuses) f. A list of the salary of and other compen- have been established and, if so; sation paid to each executive officer. a. Review specific provisions of the plans g. A list of the salary ranges for other and determine the beneficiaries. officers of the bank broken down by b. Review controls established to prevent position. the beneficiary(s) of the plan from h. A description of other employee benefits. understating noncash expenses (accrual 2. Become familiar with the quality of key expense accounts, provision for possible personnel by: loan losses, etc.) or overstating noncash a. Updating management briefs for all exec- income (accrual income accounts). utive officers and department or division 9. Review the bank’s activities with regard to heads. developing personnel for senior manage- b. Distributing the updated management ment succession. At a minimum, this review briefs to appropriate examining person- should include: nel and requesting that they be returned a. An assessment of the quality of lower upon completion. levels of management and the potential 3. Review administrative manuals and: for advancement. a. Extract any policy statements contained b. An assessment of the bank’s officer hir- therein. ing policies to determine that it is appro- b. Extract any general information consid- priate to meet the bank’s current and ered relevant in appraising management. future needs. c. Analyze the manual(s), in general, as 10. Obtain and analyze daily or other periodic useful management tools. reports submitted to executive management 4. Review management plan and extract infor- with the view of determining the usefulness mation concerning: of the reports in monitoring the condition a. Areas of bank where increased or and operation of the bank. decreased officer staffing is planned. 11. As the evaluation of the various areas of b. Number of officers to be added or examination interest are being completed, removed. discuss with assisting personnel: c. Qualification requirements for planned a. Any of their observations indicative of additional officers. the general morale level. 5. Establish the hierarchy of the organization b. The technical proficiency of officers in by determining the functional responsibility their area. levels of various officers and whether lines c. The level of direct impact that officers of authority are drawn in accordance with have on the condition of their areas. the organization chart. 12. Review the section on ‘‘Analytical Review

Commercial Bank Examination Manual March 1994 Page 1 5010.3 Management Assessment: Examination Procedures

and Income and Expense’’ and extract any 15. By reviewing the results of the preceding information related to financial planning steps and performing any other procedures that is considered relevant to evaluating deemed appropriate, answer the following management. Also consider the quality, questions (normally these questions will depth and applicability of financial serve as a summary of information planning. obtained, thus compiling factual data to 13. In conjunction with reviewing the work support your objective comments on papers and comments generated during the management): examination: a. Have overall management objectives a. Familiarize yourself with the bank’s been set? written objectives and policies. b. Does the bank forecast manpower b. Analyze those policies and determine requirements? any inconsistencies in management areas. c. Are qualified people advanced from c. Review any internal control and policy within? exceptions and any other criticisms made d. Are supervisory personnel involved in in connection with the examination of all the selection of new employees and given areas of the bank. the right of acceptance or rejection? d. Determine the extent to which improper e. Is management training given to those implementation is negating the effect of persons likely to assume higher level written policies and procedures. positions? e. Review the appropriateness of asset f. Are salaries competitive? distribution in view of the bank’s sources g. Are employee benefit programs of funds. competitive? f. Review the evaluation of the bank’s 16. Prepare comments on the quality of man- capital position and expectations in view agement supervision. The comments should, of asset quality and plans for growth and at a minimum, discuss the following: expansion. a. General and technical ability. 14. In cases where previously obtained infor- b. Effectiveness. mation is incomplete or where no records c. Experience. could be reviewed, interview appropriate d. Any inconsistencies in written objec- management in order to judge quality and tives, policies and procedures. depth. The interview should be conducted e. Any serious or widespread lack of proper in such a manner as to generate neces- implementation of written procedures. sary information for determining: f. An evaluation of the bank’s salary a. Sources of information used to keep structure. current. g. The promptness with which management b. Stengths and weaknesses of lower level addresses problems. personnel. h. The extent to which executive c. Succession of management and replace- management delegates and demands ment of key personnel. accountability. d. General management plan. i. Any evidence that executive manage- e. Methods of control utilized. ment is more concerned with the opera- f. Workload factors and efficiency of tion of a functional area than with overall personnel. supervision of the bank. g. Frequency of staff meetings and how the j. The potential for upward movement of communications system works. existing management personnel. h. Management projections for the institu- k. Management’s commitment to effecting tion over the next year. corrective action in problem areas. i. Any major new proposal being consid- l. Unsafe or unsound management. ered or changes in asset mix or services. m. Any situation which might require close j. The nature and degree of working rela- monitoring or removal of management. tionship with directors. 17. For banks that are subsidiaries of bank k. The existence of any time-consuming holding companies (BHCs), review the outside activities of executive relative degree of centralized control by management. parent or the lead bank, and evaluate:

March 1994 Commercial Bank Examination Manual Page 2 Management Assessment: Examination Procedures 5010.3

a. The general level of management’s depen- organization, examiners must be alert to the dence on central BHC staff. danger of such considerations becoming b. Independence on ﬁnal credit decisions. overly burdensome or unfair to the subsid- c. Independence on investment decisions. iary bank being examined. (Reference Fed- d. Independence on operational practices or eral Reserve Policy Statement on Inter- service fee arrangements. corporate Income Tax Accounting Transactions of Bank Holding Companies While examiners may expect that econo- and State Member Banks.) mies of scale or optimization of tax, investment, or credit considerations on a consoli- 18. Update the workpapers with any informa- dated basis may be beneﬁcial to the entire tion that will facilitate future examinations.

Commercial Bank Examination Manual March 1994 Page 3 Management Assessment Internal Control Questionnaire Effective date March 1984 Section 5010.4

1. Does the bank have an organizational chart? 14. Does top management consult with direc- 2. If not, have lines of authority and reporting tors for their opinion of future condition? responsibility been formally established? 15. Does the bank either employ an economist 3. Does the bank have a full-time personnel or utilize the services of an outside eco- manager? nomic advisor? 4. Does the bank utilize written personnel 16. Does senior management propose to the manuals? directors areas for policy decision? 5. Does the bank utilize a system of written 17. Does the bank have a management succes- job descriptions, including descriptions for sion plan? supervisory personnel? 18. Does the bank employ a marketing manager 6. Does the bank actively recruit personnel? and/or outside marketing consultant? 7. Does the bank perform background investi- 19. Does senior management receive: gations of new employees? a. A brief statement of condition daily? 8. Does the bank have a formal training b. A daily liquidity report? program? c. A listing of assets subject to quality 9. Does the bank utilize other than on-the-job limitations at least monthly? training? d. An earnings statement on a comparative 10. Does the bank utilize a graded salary scale? basis at least monthly? 11. Does the bank consider competition in 20. Does the bank’s auditing function audit the preparing a salary range? If so, in what ofﬁcer’s adherence to general policy? manner? 21. Are staff meetings held on a regular basis? 12. Does the top management at least annually 22. Are minutes kept for staff meetings? review lower management? 23. Does the bank use a system of progress 13. Does the bank prepare or utilize a long- reports on speciﬁc projects? range forecast of economic conditions ger- 24. Does the bank have a tax department or a mane to its trade area? tax consultant?

Commercial Bank Examination Manual March 1994 Page 1 Internal Controls—Procedures, Processes, and Systems (Required Absences from Sensitive Positions) Effective date April 2009 Section 5017.1

Examiners are expected to assess the adequacy ing of the internal controls system and struc- of an institution’s internal controls—the involved ture to allow for appropriate and necessary procedures, processes, and systems of its inter- changes. nal control structure. In so doing, they may refer to the available Internal Control Question- The components of internal control overlap naire(s) pertaining to the various transactions the internal control objectives. The components and activities discussed at the end of most of internal control must be addressed individu- sections of the manual. (See also section 1010.1.) ally to assess their effectiveness relative to a When assessing the adequacy of a bank’s inter- specific objective. nal control system and structure, the examiner The bank’s board of directors and senior needs to have a good understanding of the management have an important role in ensuring meaning of internal control and be able to the adequate development, execution, mainte- evaluate its design and effectiveness. Internal nance, and compliance monitoring of the bank’s control is a process initiated by a bank’s board internal controls. When determining the adequacy of directors, management, and other personnel, of a bank’s management, examiners should and is designed to provide reasonable assurance carefully analyze and review its internal control that specific objectives are achieved as to the systems, processes, and procedures. bank’s (1) effectiveness and efficiency of operations, (2) reliability of financial reporting, and (3) extent of compliance with applicable laws STATEMENT ON REQUIRED and regulations.1 The concept of control structure involves the ABSENCES FROM SENSITIVE controls that have been established and the POSITIONS control environment—management’s monitoring of procedures, activities, and attitudes. One of the many basic tenets of internal control Internal control is part of the bank’s basic is that a bank needs to ensure that its employees operations. in sensitive positions are absent from their duties for a minimum of two consecutive weeks. The components of internal control are Such a requirement enhances the viability of a sound internal control environment because most • Control environment—the environment estab- frauds or embezzlements require the continuous lished by the bank’s employees who are presence of the wrongdoer. After making this responsible for its operations, including their assessment, the bank should require that employ- ethical values, integrity, and competence ees in sensitive key positions, such as trading • Risk assessment—the identification, analysis, and wire transfer, not be allowed to transact or and management of risks otherwise carry out, either physically or through • Control activities—the institution’s estab- electronic access, their assigned duties for a lished policies and procedures that are designed minimum of two consecutive weeks per year. to provide assurance that appropriate actions, The prescribed period of absence should be which are determined by management, are sufficient to allow all pending transactions to taken to address identified risks clear. The bank should also require that an • Information and communication—the bank’s individual’s daily work be processed by another activities that provide the basis for the gath- employee during the employee’s absence. See ering and exchange of information that is SR-96-37, which emphasizes the need for a needed to conduct, manage, and control the bank to conduct an assessment of significant risk organization areas before developing a policy on required • Monitoring—the bank’s continuous monitor- absences from sensitive positions. A comprehensive system of internal controls is essential for a bank to safeguard its assets and 1. For additional information on internal controls, see the capital, and to avoid undue reputational and Committee of Sponsoring Organizations of the Treadway Commission’s study on internal controls, Internal Control— legal risk. Senior management is responsible for Integrated Framework (AICPA, 1992). establishing an appropriate system of internal

Commercial Bank Examination Manual April 2009 Page 1 5017.1 Internal Controls—Procedures, Processes, and Systems controls and monitoring compliance with that banks, particularly small community banks, system. Although no single control element might consider compensating controls such as should be relied on to prevent fraud and abuse, continuous rotation of assignments in lieu of these acts are more easily perpetrated when required absences to avoid placing an undue proper segregation and rotation of duties do not burden on the bank or its employees. exist. As a result, the Federal Reserve reempha- For the policy to be effective, individuals sizes the following prudent banking practices having electronic access to systems and records that should be incorporated into a bank’s inter- from remote locations must be denied this access nal control procedures. These practices are during their absence. Similarly, indirect access designed to enhance the viability of a sound can be controlled by not allowing others to take internal control environment, as most internal and carry out instructions from the absent frauds or embezzlements necessitate the con- employee. Of primary importance is the require- stant presence of the offender to prevent the ment that an individual’s daily work be pro- detection of illegal activities. cessed by another employee during his or her When developing comprehensive internal con- absence; this process is essential to bring to the trol procedures, each bank should first make a forefront any unusual activity of the absent critical assessment of its significant areas and employee. sensitive positions. This assessment should con- Exceptions to the required-absence policy sider all employees, but should focus more on may be necessary from time to time. However, those with authority to execute transactions, management should exercise the appropriate those with signing authority and access to the discretion and properly document any waivers books and records of the bank, as well as those that are granted. Internal auditing should be employees who can influence or cause such made aware of individuals who receive waivers activities to occur. Particular attention should be and the circumstances necessitating the paid to areas engaged in trading and wire- exceptions. transfer operations, including personnel who If a bank’s internal control procedures do not may have reconciliation or other back-office include the above practices, they should be responsibilities. promptly amended. After the procedures have After producing a profile of high-risk areas been enhanced, they should be disseminated to and activities, it would be expected that a all employees, and the documentation regarding minimum absence of two consecutive weeks per their receipt and acknowledgment maintained. year be required of employees in sensitive Additionally, adherence to the procedures should positions. The prescribed period of absence be included in the appropriate audit schedules, should, under all circumstances, be sufficient to and the auditors should be cognizant of potential allow all pending transactions to clear and to electronic access or other circumventing provide for an independent monitoring of the opportunities. transactions that the absent employee was The development and implementation of pro- responsible for initiating or processing. This cedures on required absences from sensitive practice could be implemented through a require- positions is just one element of an adequate ment that affected employees take vacation or control environment. Each bank should take all leave, the rotation of assignments in lieu of measures to establish appropriate policies, lim- required vacation, or a combination of both so its, and verification procedures for an effective the prescribed level of absence is attained. Some overall risk-management system.

April 2009 Commercial Bank Examination Manual Page 2 Internal Controls—Procedures, Processes, and Systems (Required Absences from Sensitive Positions) Examination Objectives Effective date April 2009 Section 5017.2

1. To determine whether a critical assessment 3. To ascertain whether the bank has taken all has been performed of a bank’s signiﬁcant measures to establish appropriate policies, areas and sensitive positions. limits, and veriﬁcation procedures for an 2. To ascertain that sound internal controls effective overall risk-management system. exist, including policies and procedures that 4. To establish that the appropriate audit sched- provide assurances that employees in sensi- ules and the audits include a review of tive positions are absent from their duties for minimum absence policies and procedures, a minimum of two consecutive weeks per including potential electronic access or other year. circumventing actions by employees.

Commercial Bank Examination Manual April 2009 Page 1 Internal Controls—Procedures, Processes, and Systems (Required Absences from Sensitive Positions) Examination Procedures Effective date April 2009 Section 5017.3

1. Determine that a profile of high-risk areas and maintained for an effective overall risk- and activities is performed on a regular, management system. periodic basis. 5. Determine whether the bank— 2. Ascertain if employees assigned to sensitive a. prohibits others from taking and carrying positions are required to be absent for a out instructions from the absent employ- minimum of two weeks per year while— ees, and a. pending, sensitive transactions are moni- b. prevents remote electronic access to sys- tored while they clear, and tems and records involving sensitive trans- b. daily work is monitored and processed by actions during the regularly assigned em- another employee during the regularly ployee’s required minimum two-week assigned employee’s absence. absence. 3. Determine if required internal control proce- 6. Ascertain if waivers from the bank’s two- dures for minimum absences (for example, week minimum absence policies and proce- rotation of assignments, vacation or leave, or dures involving sensitive positions are a combination of both) are being used in documented. sensitive operations such as trading, trust, 7. Determine that the appropriate audit sched- wire transfer, reconciliation, or other sensi- ules and the audits include a review of such tive back-office responsibilities. procedures, including potential electronic 4. Ascertain if appropriate policies, limits, and access or other circumventing actions by verification procedures have been established employees.

Commercial Bank Examination Manual April 2009 Page 1 Overall Conclusions Regarding Condition of the Bank Effective date April 2008 Section 5020.1

The examiner is encouraged to use objective • present asset quality; criteria in evaluating various areas of the bank. • current liquidity position; However, there will always be a need for sub- • present capital adequacy; jective judgment in an examination. Formulat- • quality and performance of management; ing an overall conclusion regarding the present • earnings performance, both past and present; and future condition of the bank requires the use and of both objective criteria and subjective judg- • sources and applications of funds. ment. As experience is essential in evaluating information in areas requiring subjective judg- The examiner-in-charge usually will include ment, the procedures in this section should be remarks regarding those areas in the examina- performed by the examiner-in-charge. In per- tion report. Although procedural areas of this forming these procedures, the examiner’s pri- manual deal specifically with each of those key mary concerns are— items, the examiner-in-charge should use information from all phases of the examination. • to make the ultimate determination as to— For example, when reviewing the bank’s present — the solvency of the bank and its ability to capital position, the examiner-in-charge may meet maturing and unusual demands in the use knowledge of the bank’s asset and manage- ordinary course of business, ment quality to modify the conclusions of assist- — adherence to safe and sound banking ing personnel. The important point is that the practice, examiner-in-charge is in the best position to — adherence to the law, and assess all information provided by the examination process. — the continued viability of the institution, Factors affecting the future condition of the and bank can generally be categorized as internal or • to communicate the results of the examination external. The examiner’s review of current con- to the Federal Reserve System and the direc- dition flows naturally into an evaluation of tors of the bank. internal factors affecting the institution’s future The evaluation of the overall condition of the prospects and condition. Among the items pro- bank is based on conditions found throughout viding insight into future conditions are— the institution. Considerations include internal • earnings trends, control and policy exceptions, violations of law • successor-management plans, and regulations, quality of management, ade- • the budget or profit plan, quacy of earnings and capital, quantities of criti- • the capital plan, and cized assets, and other identified deficiencies or • any other internally generated projections or irregularities. An evaluation of the future con- forecasts. dition of the bank is based on the analysis of— Many banks will not have formal written • management’s plans as expressed by operat- plans or projections. In such cases, the examiner- ing plans, the capital plan, and other in-charge must obtain from senior management projections, or the board of directors information on their • factors such as competition and economic plans for matters such as— conditions, and • the overall present condition of the bank. • growth and expansion, • capital, The primary information for evaluating the • changes in the size and mix of assets, and present condition of a bank is the findings and • changes in sources of funding. conclusions of the assisting personnel. The examiner-in-charge should weigh the impor- In addition, examiners should remind senior tance and significance of all criticisms, excep- management that any change in the general tions, and deficiencies in attempting to discover character of a bank’s business or the scope of any unfavorable trends or situations. Through the corporate powers it exercises requires the review of the examination process, insight can prior approval of the Board under Regulation H. be gained into such central issues as— The examiner should recommend that banks

Commercial Bank Examination Manual April 2008 Page 1 5020.1 Overall Conclusions Regarding Condition of the Bank that do not have formal plans or projections take affect capital, liquidity, and compliance with advantage of any externally available tools to laws should be evaluated for their potential aid them in formulating these plans. In today’s effect on the safety and soundness of the bank. competitive market, strategic planning is a In judging such controversial areas as capital necessity for almost all banks, but especially for adequacy and liquidity, the examiner should banks that are losing their market share or in remember that, under ideal circumstances, man- which inefficiencies are depressing profit- agement should be the expert on the bank’s ability. capitalization and liquidity position. Judgments If banks prepare budgets or profit plans, on such matters should be generated internally, insight can be gained into the accuracy of based on insight only management can possess. balance-sheet and earnings projections by com- It is management that should know the bank’s paring actual and projected account balances. competitive situation, the economics of the It also is beneficial to compare original projec- service area, and the anticipated impact of those tions with current projections to determine that and other factors on its plans for growth and adjustments are made on a timely basis. When expansion. It is also management that has the four- or five-year projections are made, banks greatest interest in the success of the bank. often formulate several forecasts based on dif- Accordingly, management and the directorate ferent sets of assumptions. In such a situation, should choose a level of capitalization and the examiner should attempt to determine the liquidity consistent with their perception of the bank’s most likely future course. bank’s situation rather than reacting to com- The examiner should attempt to gain access to petitors or relying on pressures from regulators. any official material or internal workpapers that However, specific judgments by the examiner document or illustrate the bank’s rationale in are required, particularly in situations where a planning its future. The goal is to review the capital or liquidity position has fallen below institution’s decision-making process. what examiners consider to be acceptable norms. Banks are turning increasingly to off-balance- Objective justification for lower levels of capital sheet activities to deliver services, effect pay- or liquidity must be obtained and analyzed. ments, generate income, and hedge interest-rate To properly evaluate the future prospects of a risks. Banks have introduced a wide variety of bank, the examiner must review external factors new products and services to complement their affecting the institution. Significant among those more traditional activities. Although these new factors are the characteristics of a bank’s area. activities are useful and profitable, they contain Area refers to the bank’s primary service area, an element of risk. Many of these new activi- which is defined as that area from which the ties involve a contingent liability or other risk bank receives approximately 75 percent of its that is not reflected on the bank’s balance sheet deposits. Demographics of the area generally are and, indeed, may not even be fully recognized available, and every bank should accumulate by the bank. The examiner should be aware of such information to aid in analyzing its current how the bank manages and controls its off- operations and planning for future operations. balance-sheet risks. Examples of off-balance- The absence of such information in an up-to- sheet activities include— date form should be considered a deficiency. Included under examination procedures for this • guarantee contracts, retained or contingent section is a listing of minimum information interests, and variable interests, required to ascertain the demographics of a • commitments and innovative applications for service area. The examiner-in-charge should standby letters of credit, and make sure that information is compiled and • a wide variety of financial instruments and should analyze it to determine whether manage- investment-security activities (including futures ment expectations appear justifiable in the and forwards, warrants, puts, and calls). circumstances. In dealing with competitive factors, the exam- Risk can be distinguished primarily as credit iner should review or compute the share of risk, liquidity, market (price, interest rate, for- market for the bank under examination. Con- eign exchange), reputational, and legal risk, or tinuing records in that area establish an analyz- risk resulting from internal control deficiencies. able trend. Consideration also should be given Examiners must be aware of the nature and to changes in the bank’s statutory and regulatory extent of off-balance-sheet risks. The risks that environment, such as—

April 2008 Commercial Bank Examination Manual Page 2 Overall Conclusions Regarding Condition of the Bank 5020.1

• changes in branching laws, one to five, one being the highest or best • changes in tax structure, and possible score. Thus, a bank with a composite • changes in laws affecting competition with rating of one requires the lowest level of super- other financial institutions. visory attention, while a five-rated bank has the most critically deficient level of performance Once the examiner has reached specific con- and therefore requires the highest degree of clusions about the present condition and future supervisory attention. When appraising the six prospects of the bank, or has noted serious key assessment areas and assigning a composite deficiencies or detrimental trends, his or her rating, the examiner weighs and evaluates all conclusions and suggestions should be commu- relevant factors. In general, these factors include nicated to bank senior management, the board of the adequacy of the capital base, net worth, and directors, and the Federal Reserve Bank on a reserves for supporting present operations and timely basis. In formulating discussion and writ- future growth plans; the quality of loans, invest- ten comments, the examiner should avoid the ments, and other assets; the ability to generate appearance of second-guessing management. earnings to maintain public confidence, cover Therefore, conclusions, judgments, and recom- losses, and provide adequate security and return mendations should be based on objective infor- to depositors; the ability to manage liquidity and mation generated throughout the entire exam- funding (in particular, during periods of increased ination process. financial stress); the ability to meet the commu- Before preparing examination report com- nity’s legitimate needs for financial services and ments regarding the overall condition of the cover all maturing deposit obligations; and the bank, the examiner-in-charge should consider ability of management to properly administer all the reporting objective. Once it is determined aspects of the financial business and plan for that problems exist in a bank, the underlying future needs and changing circumstances. The causes must be identified. Those underlying assessment of management and administration causes as well as specific problems or deficien- includes the quality of internal controls, operat- cies should be covered in the comments. For ing procedures, and all lending, investment and example, if deficiencies in written lending operating policies; compliance with relevant objectives or policies or noncompliance with laws and regulations; and the involvement of the sound policies has resulted in the acquisition of directors, shareholders, and officials. sub-quality assets, the examiner’s comments Although the composite rating is based loosely must address both cause and effect. The total of on the average of the six component scores, the criticized assets should be cited as evidence of examiner’s judgment can and should play a the underlying problem, and appropriate rem- major role in its determination. Thus, the exam- edies, such as changing objectives or policies, iner must assess the severity, particularly the should be suggested. potential impact, of individual weaknesses on Examiners should remember that their ability the present and future viability of the bank. to reach accurate conclusions regarding the Significant problems will provide sufficient overall present condition and future prospects of basis for deviating from the numerical-average the bank and their skill in communicating the approach to assigning the composite rating. conclusions to management orally and in reports However, whenever deviation from the numeri- will, to a great extent, determine the effective- cal standards for the composite rating is neces- ness of the entire examination process. sary to accurately reflect the overall condition of The examiner’s conclusions regarding the the bank, the examiner must provide a full overall condition of the bank are summarized in explanation of the reasons for such deviation. a composite rating assigned in accordance with See the appendix (section A.5020.1) for a com- guidelines provided under the Uniform Inter- plete discussion of the uniform rating system agency Bank Rating System (CAMELS). The and considerations to be taken into account composite rating represents an overall appraisal when using it to evaluate the condition of a of six key assessment areas (components) cov- bank. ered under the CAMELS rating system: Capital, Asset quality, Management, Earnings, Liquidity, SUBSIDIARIES OF BANK and Sensitivity to market risk. The summary, or HOLDING COMPANIES composite, rating, as well as each of the assessment areas, is delineated on a numerical scale of The composite rating of an individual subsidiary

Commercial Bank Examination Manual April 2008 Page 3 5020.1 Overall Conclusions Regarding Condition of the Bank bank should be based on the condition of that nonpublic confidential supervisory information single entity. The quality of management and to insurers as well as other nonrelated third the financial condition of the consolidated orga- parties without permission from their appropri- nization will be useful in assessing the prospects ate federal banking agency. (See SR-07-19, and understanding the operations of the bank SR-05-4, SR-96-26, and SR-88-37.) being examined. However, banks with weak- Federal banking regulations provide that the nesses requiring corrective action should be report of examination, which contains the identified as such. Then, appropriate supervisory CAMELS rating, is nonpublic information and focus can also be made at the consolidated level. is the property of the agency issuing the report.3 Also, banks should be identified by type on an These regulations specifically provide that, individual basis rather than by applying the except in very limited circumstances, banks and consolidated organization’s characteristic to each other financial institutions may not disclose a bank. For example, the capital and condition of report of examination or any portion of the a community bank should be judged by commu- report, nor make any representations concerning nity bank standards, not by multinational or the report or the report’s findings, without the regional standards, even if the bank is owned by prior written permission of the appropriate fed- such an organization. This approach recognizes eral banking agency.4 The circumstances for that two consolidated organizations of similar release of nonpublic supervisory information size may be composed of entirely different types may include disclosure to a parent holding of banks. Proper evaluation of each bank com- company, a director, an officer, an attorney, an ponent should lead a bank holding company auditor, or another specified third party, as examiner to the most appropriate conclusion on indicated in the regulations of the appropriate the condition of the consolidated entity. federal banking agency.5 Any person who dis- closes or uses nonpublic information except as expressly permitted by one of the appropriate CONFIDENTIALITY OF THE federal banking agencies or as provided by the SUPERVISORY RATING agency’s regulations may be subject to the criminal penalties provided in 18 USC 641. AND OTHER NONPUBLIC The legal prohibition on the release of non- SUPERVISORY INFORMATION public supervisory information applies to all financial institutions supervised by the agencies, A February 28, 2005, interagency advisory including bank and thrift holding companies, reminds banking organizations of the statutory Edge corporations, and the U.S. branches or prohibitions on the disclosure of supervisory agencies of foreign banking organizations, which ratings and other confidential supervisory infor- receive confidential supervisory ratings, includ- 1 mation to third parties. The agencies learned ing the RFI/C(D) rating, ROCA rating, CORE that some insurers had requested or required rating, and CAMEO rating.6 As with the banks and savings associations (financial institutions) to disclose their CAMELS rating during 3. For the Federal Reserve, see 12 CFR 261.2(c)(1), the underwriting process when those institutions 261.20(g), and 261.22(e). had sought directors’ and officers’ liability 4. See 12 CFR 261.22. (D&O) coverage.2 The agencies responded by 5. See 12 USC 326 and 12 CFR 261.20(b) (exceptions). issuing the advisory specifically to remind all 6. RFI/C(D), ROCA, and CAMEO ratings are assigned by the FRB as a result of an examination or inspection. As of banking organizations that, except in very lim- January 1, 2005, the FRB adopted a new rating system, ited circumstances, they are prohibited by law RFI/C(D) ratings, for bank holding companies that replaces from disclosing their CAMELS rating and other the former BOPEC rating system. RFI/C(D) ratings components are Risk management, Financial condition, potential Impact of the parent and nondepository subsidiaries on the 1. The Board of Governors of the Federal Reserve System subsidiary depository institutions, Composite, and Depository (FRB), the Office of the Comptroller of the Currency (OCC), institution. For noncomplex bank holding companies with the Federal Deposit Insurance Corporation (FDIC), and the assets of $1 billion or less, only risk-management and com- Office of Thrift Supervision (OCC). posite ratings are assigned. ROCA ratings are assigned to the 2. As part of the examination process, a confidential U.S. branches, agencies, and commercial lending companies supervisory rating, called a CAMELS rating, is assigned to of foreign banking organizations. The ROCA rating compo- each depository institution regulated by the agencies. See the nents are Risk management, Operational controls, Compli- appendix section A.5020.1 for a complete description of the ance, and Asset quality. CORE ratings are assigned to Uniform Financial Institutions Rating System or CAMELS complex holding company enterprises. The CORE rating rating system. components are Capital, Organizational structure, Relation-

April 2008 Commercial Bank Examination Manual Page 4 Overall Conclusions Regarding Condition of the Bank 5020.1

CAMELS rating, these ratings are transmitted to • any reports or other sources of information on the regulated institutions in reports of inspection institution performance or internal matters or examination, which are the property of the created by the institution that does not contain agencies. information prohibited from release by law or Financial institutions that receive requests for regulation confidential supervisory ratings should refer all requesters to the following publicly available The National Association of Insurance Com- information in lieu of disclosing any confidential missioners (NAIC) was advised by the agencies regulatory information, including the CAMELS that some insurers were inappropriately request- rating. (See the National Information Center, on ing or requiring disclosure of CAMELS ratings the Federal Financial Institutions Examination as a part of the underwriting process. The Council (FFIEC) website, www.ffiec.gov/.) agencies requested NAIC’s assistance in notify- ing insurance companies that this practice should • for banks, an institution’s quarterly reports of be discontinued because of the confidential condition (Call Reports) (see 12 USC 1817) nature of the CAMELS rating. • for holding companies or foreign banks with U.S. operations, an institution’s quarterly and annual FR Y or H-(b)11 reports (see 12 USC 1844, 3106, 3108, 601–604a, and 611–631) FORMAL AND INFORMAL • for national banks, the annual disclosure state- SUPERVISORY ACTIONS ment (see 12 CFR 18.3) • for banks, the institution’s Uniform Bank As a general rule, supervisory action should Performance Report (UBPR), which is avail- be considered when other more routine mea- able to all interested parties at the website sures, such as formal discussions with a bank’s www.ffiec.gov and is designed for summary principals or directors and normal follow-up and in-depth analysis of banks; for savings procedures, have failed to resolve supervisory associations, the Uniform Thrift Performance concerns. The Uniform Interagency Bank Rating Report (UTPR), available from the OTS upon System clearly identifies the more serious request problem banks and distinguishes them from banks whose weaknesses or deficiencies are such • an institution’s publicly available filings, if as to warrant a lower degree of supervisory any, filed with the appropriate federal banking concern. agency (15 USC 78(l)(i)) or with the U.S. Securities and Exchange Commission For example, the application of prompt and effective remedial action may keep the condition • any reports or ratings on the institution com- of a composite 3 bank from deteriorating and the piled by private companies that track the bank from becoming a problem institution. To performance of financial institutions7 ensure problem areas receive adequate attention, • any reports or ratings issued by private rating all weaknesses should be clearly defined and services on public debt issued by an institution corrective measures should be properly struc- • any publicly available cease-and-desist order tured. This objective may best be achieved or enforcement proceeding against an through the execution of a memorandum of 8 institution understanding between the bank’s board of directors and Reserve Bank officials. A memorandum of understanding is not a formal written ship, and Earnings. CAMEO ratings are assigned to Edge agreement as prescribed in the Financial Insti- corporations and the overseas branches and subsidiaries of U.S. banks. The CAMEO ratings components are Capital, tutions Supervisory Act of 1966 (as amended); it Asset quality, Management, Earnings, and Operations and is a good faith understanding between the bank’s internal controls. directorate and the Reserve Bank concerning the 7. For bank rating services, see the guidance at principal problems and the bank’s proposed www.fdic.gov/bank/individual/bank/index.html. 8. Information on enforcement actions taken by the Federal remedies. Reserve may be found at www.federalreserve.gov/boarddocs/ Banks rated composite 4 or 5 are clearly enforcement/search.cfm. Information on enforcement actions problem institutions that require close and con- taken by other federal agencies, such as the Securities and stant supervisory attention. Unless specific cir- Exchange Commission, the Financial Crimes Enforcement Network, and the Department of Justice, as well as foreign cumstances argue strongly to the contrary, such authorities, may also be publicly available. banks will be presumed to warrant formal super-

Commercial Bank Examination Manual April 2008 Page 5 5020.1 Overall Conclusions Regarding Condition of the Bank visory action, that is, a written agreement or Examiners are responsible for the initial analy- cease-and-desist order, as provided for in the ses on potential civil money penalties. Civil Financial Institutions Supervisory Act of 1966. money penalties should be proposed for serious In addition, the Board of Governors is autho- violations and for violations which, because of rized to suspend and remove offending officers their frequency or recurring nature, show a and directors of banks for certain violations and general disregard for the law. After the examiner activities. has reviewed the facts and decided to recom- Although the decision to pursue formal or mend a civil money penalty, he or she should informal supervisory actions belongs to the contact the Reserve Bank for advice on proper Board of Governors or the Reserve Bank, the documentation and any other assistance. initial consideration and determination of whether action is necessary usually results from the examination process. Accurate and complete report comments that carefully delineate both SUSPICIOUS-ACTIVITY- the bank’s weaknesses and deficiencies, as well REPORTING PROCEDURES as management’s existing or planned corrective measures, will allow the Reserve Bank to make On April 2, 1985, the federal financial institu- the most informed decision concerning appro- tions supervisory agencies and the U.S. Depart- priate supervisory action. ment of Justice signed an agreement that requires the agencies to work toward improving the federal government’s response to white-collar crime in federally regulated financial institu- CIVIL MONEY PENALTIES tions. The primary goal of the agreement is to ensure full cooperation in the sharing of relevant Under provisions of the Financial Institutions information among the agencies—subject to Regulatory and Interest Rate Control Act of existing legal restrictions—so that all available 1978 (FIRA) (P.L. 95–630), the Board of Gov- information may be used in criminal, civil, and ernors is authorized to assess civil money pen- administrative proceedings. In keeping with that alties for violation of the terms of a final goal, in 1985 the Federal Reserve, along with cease-and-desist order and violations of— the other federal financial institutions regulatory agencies, issued procedures to be used by banks • sections 19, 22, and 23A of the Federal and other financial institutions operating in the Reserve Act (respectively, reserve require- United States to report known or suspected ments and interest-rate limitations; limitations criminal activities to the appropriate law enforce- on loans by insured banks to their executive ment authorities and bank supervisors. Since officers, directors, and principal shareholders; 1996, the federal financial institutions supervi- and limits on loans by insured banks to their sory agencies and the Department of the Trea- affiliates); sury’s Financial Crimes Enforcement Network • the prohibitions of title VIII of FIRA against (FinCEN) have required banking organizations preferential lending to bank executive officers, to report known or suspected violations of law directors, and principal shareholders based on as well as suspicious transactions on a Suspi- a correspondent-account relationship; and cious Activity Report by Depository Institutions • a willful violation of the change in Bank (SAR-DI). Law enforcement agencies use the Control Act of 1978 (12 USC 1817(j)). information reported on the SAR-DI form to initiate investigations, and Federal Reserve staff In determining the appropriateness of initiat- use the information in their examination and ing a civil money penalty assessment proceed- oversight of supervised institutions. ing, the Board has identified a number of relevant factors (see Federal Reserve Regulatory Service,3–1605). In assessing a civil money Suspicious Activity Report by penalty, the Board is required to consider the Depository Institutions size of the financial resources and good faith of the respondent, the gravity of the violation, the Filing history of previous violations, and such other matters as justice may require. A member bank must file a SAR-DI form with

April 2008 Commercial Bank Examination Manual Page 6 Overall Conclusions Regarding Condition of the Bank 5020.1 the appropriate federal law enforcement agen- SAR-DI form filed, as well as the original or cies and the Department of the Treasury. (See business-record equivalent of any supporting section 208.62 of the Board’s Regulation H.)9 documentation, for a period of five years from Member banks must prepare a SAR-DI form in the date of the filing of the SAR-DI form. accordance with the form’s instructions (see Supporting documentation is to be identified and SR-07-2 and the attached June 2007 SAR-DI maintained by the bank, and it will be deemed to form and instructions); the completed SAR-DI have been filed with the SAR-DI form. All form is to be sent to the U.S. Treasury Depart- supporting documentation must be made avail- ment. A SAR-DI report form must be filed when able to appropriate law enforcement agencies on an institution detects— request.

• insider abuse involving any amount, • violations aggregating $5,000 or more in which Referral of Criminal Matters and the a suspect can be identified, Monitoring of SAR-DI Forms • violations aggregating $25,000 or more regardless of a potential suspect, or The Enforcement Section of the Division of • transactions aggregating $5,000 or more that Banking Supervision and Regulation has pri- involve potential money laundering or viola- mary responsibility for the referral of criminal tions of the Bank Secrecy Act. matters for the Federal Reserve System to the appropriate authorities. The Anti-Money- The management of a member bank must Laundering Policy and Compliance Section of promptly notify its board of directors, or a the division develops, implements, and monitors committee thereof, of any SAR-DI form filed. the System’s suspicious-activity-reporting examination procedures. SR-letters have been distributed within the Federal Reserve System. Time for Reporting Letters relevant to the reporting of suspicious activities include SR-07-2, SR-01-29, and SR- A member bank is required to file a SAR-DI 03-17. Any inquiry relating to suspicious- form within 30 calendar days after the date of activity reporting should refer to the applicable initial detection of the facts that may constitute SR-letter. a basis for filing a SAR-DI form. If no suspect was identified on the date of detection of the incident requiring the filing, a member bank Interagency Guidance on Sharing may delay filing a SAR-DI form for an addi- Suspicious Activity Reports with tional 30 calendar days in order to identify the suspect. Reporting may not be delayed more Head Offices and Controlling than 60 calendar days after the date of initial Companies detection of a reportable transaction. For violations requiring immediate attention, such as On January 20, 2006, the federal banking agen- 10 when a reportable violation is ongoing, the cies issued for banking organizations the financial institution is required to immediately Interagency Guidance on Sharing Suspicious notify an appropriate law enforcement authority Activity Reports with Head Offices and Control- and the Board by telephone, in addition to filing ling Companies. The guidance confirms that a timely SAR-DI form. (1) a U.S. branch or agency of a foreign bank may disclose a SAR-DI form to its head office outside the United States and (2) a U.S. bank or Retention of Records savings association may disclose a SAR-DI form to controlling companies,11 whether A member bank must retain a copy of any 10. The Board of Governors of the Federal Reserve Sys- 9. The Board’s SAR-DI form rules apply to state member tem, the Federal Deposit Insurance Corporation, the Office of banks, bank holding companies and their nonbank subsidiaries the Comptroller of the Currency, and the Office of Thrift that do not report on a different SAR-DI form (for example, Supervision, along with the Department of Treasury’s Finan- broker-dealers), Edge and agreement corporations, and the cial Crimes Enforcement Network. U.S. branches and agencies of foreign banks supervised by the 11. A controlling company is defined as (1) a bank holding Federal Reserve. company, as defined in section 2 of the Bank Holding

Commercial Bank Examination Manual May 2007 Page 7 5020.1 Overall Conclusions Regarding Condition of the Bank domestic or foreign. The guidance notes that Reporting of Suspected Criminal banking organizations must maintain appropri- Violations ate arrangements for the protection of confidentiality of SAR-DI forms.12 During the course of an examination, if an The guidance does not address whether a examiner (1) uncovers a situation that is known banking organization may share a SAR-DI form or suspected to involve a criminal violation of with an affiliate other than a controlling com- any section of the United States Code or state pany or head office, whether located inside the law and (2) finds that no referral, or an inad- United States or abroad. Until further guidance equate referral, has been made by the bank, he on this topic is issued, banking organizations or she should report the situation immediately to should not share SAR-DI forms with such the appropriate Reserve Bank. If the situation affiliates. warrants, a telephone call should be made to the examiner-in-charge (EIC) or the central point of contact (CPC), as applicable. Examination Objectives The examiner should follow up the call with the submission of a detailed report. The EIC or The examiner should determine if an institution the CPC should promptly convey the informa- has established internal procedures to ensure the tion to the appropriate enforcement officer at the prompt and accurate submission of all reports of Reserve Bank, who will expeditiously notify suspected criminal activity to the appropriate and consult with the Enforcement Section in the authorities. The institution’s procedures must Board’s Division of Banking Supervision and comply with the requirements for suspicious- Regulation. The examiner’s report to the EIC or activity reporting in section 208.62 of the the CPC should be in the form of a memoran- Board’s Regulation H (12 CFR 208.62) and dum that fully apprises the Reserve Bank of the with the Bank Secrecy Act compliance program situation. All of the information reported in the (12 CFR 208.63). SAR-DI form, as well as information held by the institution to support the SAR-DI form, should be included in the memorandum. Copies of Examination Procedures pertinent exhibits or material should be attached to the memorandum. The examiner should— The examiner’s report should be confined to clear-cut statements of fact and must not contain • determine whether the institution has a policy opinions as to the probability of indictment, of reporting suspected criminal activity, conviction, or related matters. In all reports and • determine how the policy has been communi- workpapers, the examiner should be as specific cated to officers and employees, and as possible. For example, rather than using • determine whether a person or department in phrases such as ‘‘it is reported’’ or ‘‘the bank the bank has been designated as being respon- indicates,’’ the examiner should identify who sible for the filing of SAR-DI forms. reported the matter and how it occurred. On each transaction reported, copies of all documentation should be obtained and placed in a separate file detailing who handled the transaction in the bank. The reporting of the matter within the bank should be chronologically referenced throughout the documentation. The copies of Company Act, or (2) a savings and loan holding company, as defined in section 10(a) of the Home Owners’ Loan Act. For documentation should be initialed and dated by purposes of the guidance, a controlling company also includes the examiner in case the original is destroyed. a company having the power, directly or indirectly, to (1) di- The documentation is extremely important to rect the management or policies of an industrial loan company proving a particular transaction. or a parent company or (2) vote 25 percent of any class of voting shares of an industrial loan company or a parent The examiner’s initial notification of sus- company. pected criminal violations to the Reserve Bank 12. FinCEN concurrently issued similar guidance for and the transmittal of data should be accom- securities broker-dealers, futures commission merchants, and introducing brokers in commodities. (See SR-06-1 and its plished without informing bank personnel. Only attachments.) the Reserve Bank or a designated representative

May 2007 Commercial Bank Examination Manual Page 8 Overall Conclusions Regarding Condition of the Bank 5020.1 should inform bank personnel or its board of violation using the SAR-DI form or that the directors of a suspected criminal violation that bank made an inadequate referral and, upon had not been reported by the bank or that had request, still fails to ﬁle a report, the Reserve been inadequately reported by bank personnel. Bank’s staff must then complete a SAR-DI After reviewing the information submitted by form. Appropriate comments relating to a bank’s the examiner, the Reserve Bank will decide failure, if any, to ﬁle all necessary SAR-DI whether the facts support the examiner’s con- forms promptly and accurately must be made in tention that a possible unreported violation of the report of examination of the bank. Repeated the criminal statutes exists. If the Reserve Bank, or serious problems in this area should be after consulting with the Board’s Enforcement directed through the Reserve Bank to the Section, discovers that in a particular instance a Enforcement Section of the Division of Banking bank failed to report the suspected criminal Supervision and Regulation.

Commercial Bank Examination Manual May 2007 Page 9 Overall Conclusions Regarding Condition of the Bank Examination Objectives Effective date March 1984 Section 5020.2

1. To reach conclusions regarding the present 4. To determine the bank’s adherence to safe condition of the bank. and sound banking practices. 2. To reach conclusions regarding the future 5. To formulate recommended action, when prospects of the bank. appropriate, based on those conclusions. 3. To determine the bank’s ability to meet 6. To communicate conclusions and recommen- demands in the ordinary course of business dations both orally and in the examination or reasonably unusual circumstances. report.

Commercial Bank Examination Manual March 1994 Page 1 Overall Conclusions Regarding Condition of the Bank Examination Procedures Effective date May 1988 Section 5020.3

Inasmuch as the following procedures are aggressiveness, hours of business and largely dependent on information generated from additional services offered by competitor all phases of the examination, the examiner-in- institutions. charge should complete this program during the g. Determine the effect of government final stages of the examination. The completion employment or dependence on govern- of this program generally can be best accom- ment contracts on the community. plished during the review of the workpapers. h. Consider the condition of the national economy with particular attention to the 1. Analyze any available information concern- rate of inflation, national vs. local unem- ing the characteristics of the area in which ployment, current interest rates and the bank operates to determine the existence government fiscal and monetary policy. of any unusual situations, any significant Specific problems, peculiar to a particu- trends, the potential impact on the bank of lar area should be investigated more any expected changes or any other signifi- thoroughly. cant information which could be detrimen- 2. Review comments and conclusions con- tal to the bank. The bank should be contained in the workpapers which were gen- sulted for sources of information which erated throughout the examination and per- might include the most recent census data form the following: or data generated by organizations, such as a. Compile all criticisms, exceptions and the Chamber of Commerce. In analyzing deficiencies. the bank’s trade area: b. Determine the existence of contradictory a. Consider density, income levels, general conclusions. age group of the residents. Determine if c. Consider the relative significance of there are significant changes in any of criticisms, exceptions, deficiencies and the above factors. conclusions and segregate important b. Determine the predominant living accom- criticisms for the final review with man- modations in the area (owner occupied agement and for incorporation into the vs. rental), price/rent levels and avail- report of examination. ability of residential units. Determine 3. Based on procedures performed and conclu- whether there are any major residential sions contained in the workpapers, answer construction projects, re-zoning or con- the following specific questions. These ques- versions of single to multiple units which tions are intended as guidelines to the will have a significant effect on the bank. examiner-in-charge in formulating overall c. Consider the types of industry and the conclusions regarding the condition of the number of firms in the area with empha- bank and should be augmented by the sis on determining concentrations or sea- examiner’s knowledge of the bank. ‘‘Yes’’ sonality. Investigate any major labor answers, in many instances, evidence the contract expirations, competitive factors existence of a ‘‘leading’’ indicator of dete- or other significant factors which could rioration of bank soundness. For any ques- have a negative effect on the community. tion with a ‘‘yes’’ answer, specify any d. Consider the types of major products, mitigating circumstances in the comments available markets and present and pro- column. Sub-question answers are for infor- jected prices for the products. mation purposes. e. Consider any expected changes in street facilities which will significantly affect bank’s accessibility/convenience. a. Asset Quality Determine the availability of public transportation. • Is there an increasing ratio of criticized f. Review the number and types of institu- assets to total capital? tions that provide similar financial ser- — If so, is it indicative of adverse vices in the community. Consider the economic conditions, poor credit

Commercial Bank Examination Manual March 1994 Page 1 5020.3 Overall Conclusions Regarding Condition of the Bank: Examination Procedures

judgment, or other factors • Do key bank officers have educational (specify)? and/or experience levels below that • Has there been a material increase in considered minimal in the circum- the quantity of non-earning assets? stances? • Is there any abnormally increasing • Is there any tendency toward over trend of past-due loans and/or interest reliance on essentially untrained and earned but not collected? unskilled clerical staffs? — If so, is it indicative of general • Is there a large disparity between the economic conditions in the bank’s compensation level of the chief exec- trade area utive officer and other members of — Is the trend indicative of a weak- executive management? ening of collection policies and — If so, is that disparity an objective procedures, a slackening of credit indication of disproportional dom- standards, the bank’s failure to rec- ination of the bank’s affairs? ognize an asset which should be in • Has the bank instituted any systems a non-earning category, or is it which directly reward managers for caused by some other factor? increasing bank income from assets or • Has a trend developed wherein the services subject to their control? bank assumes increased risk without — If so, has the bank failed to insti- receiving increased rewards? tute necessary control and audit • Do the portfolios exhibit high concen- procedures to prevent abuses? trations in specific industries? • Has the bank failed to institute any — If so, do the concentrations repre- programs which would give officers a sent a significant actual or contin- vested interest in remaining with the gent problem? bank? • Has the overall quality of assets dete- — If so, would the institution of such riorated since the last examination? a program offer a workable solu- — If so, is the deterioration recog- tion to an actual or potential officer nized by management and the board turnover problem? of directors? Can the deterioration • Is the bank’s strategic and operational be attributed to factors beyond the planning inadequate? control of management or the board • Is the board of directors unresponsive of directors, such as a change in to internal or external suggestions for the general economic conditions of improvement in the bank? the bank’s service area? • Are the following conditions present? — If deterioration results from inter- — Infrequent meetings of board of nal factors, such as lowering of directors. credit standards or poor credit judg- — Infrequent meetings of committees ment, have steps been taken by of the board. management to effectively reverse — Infrequent management committee negative trends? meetings. — A directorate which is split into distinct voting groups. b. Quality of Management — If so, are directors viewed as failing to perform their functions • Has the executive management changed adequately? since the last examination? • Is the quality of management deemed — If so, is the change detrimental to inadequate to conduct the affairs of the bank? the bank in a reasonable and safe • Has there been any change in the manner? general banking philosophy of execu- • Are training programs and compensa- tive management? tion increments deemed inadequate to — If so, is that detrimental to the attract and retain a staff capable of bank? providing management succession?

March 1994 Commercial Bank Examination Manual Page 2 Overall Conclusions Regarding Condition of the Bank: Examination Procedures 5020.3

c. Earnings of criticized assets, the competency of management, etc.? • Are earnings static or moving down- ward as a percentage of total resources? e. Liquidity • Is there a trend of decreasing income before security gains and losses as a • Is there a trend toward decreasing percentage of total revenues? bank liquidity? — If so, is such a trend expected to • Has the bank been forced to increase continue? abnormally dependence on borrowed — If so, has management determined funds to support existing assets? causes for any deterioration and • Does the bank depend excessively on taken action to reverse the negative purchased funds? trend? • Is there a trend toward investing inter- • Has the ratio of operating expenses to est sensitive liabilities in non-interest operating revenues been increasing? sensitive assets? • Are earnings trends consistent? • Do the present quantity and maturity • Has a decreasing spread between of non-interest sensitive assets repre- interest earned and interest paid sent a dangerous or potentially danger- developed? ous situation? • Are the bank’s earnings signiﬁcantly vulnerable to changes in interest rate levels? f. Off-Balance-Sheet Risk — If so, what are management’s plans and prospects for altering the Loans Sold or Serviced vulnerability? • Are there any signiﬁcant structural • Is the bank involved as the lead or changes in the balance sheet which agent in loan participations, syndica- may impact earnings? tions, or servicing activities to the • Has the bank experienced increasing extent that management expertise is actual loan losses and/or loan loss inadequate, or to the extent that the provisions? volume exceeds the level which man- • Is there any evidence that sources of agement can capably handle? interest and other revenues have • Does the bank’s record of pending or changed since that last examination? threatened litigation indicate any — If so, is that attributed to an instances where the bank, as lead or unsound emphasis for increased agent in a loan participation or syndi- earnings? cation, has willfully misrepresented • Are earnings deemed inadequate to the credit to the other participants, or provide increased capitalization com- otherwise acted with gross negligence mensurate with the bank’s growth? in handling the credit? — If so, is there any indication that the participants intend to hold the d. Capital bank liable for any loss incurred on the credit? • Has the bank been unable to maintain • Did the examination reveal a practice a normal growth rate for capital? of improper origination and packaging • Do the ratios of loans to capital, depos- of loans sold or serviced which could its to capital or total assets to capital cause: exhibit a trend to abnormal increases? — The bank being compelled to • Is capital deemed inadequate to sup- repurchase the package, or port the present volume of business, — In the case of government guaran- including the volume of off-balance- teed loans, the complete or partial sheet activities, in view of the amount dishonor of the guaranty?

Commercial Bank Examination Manual March 1994 Page 3 5020.3 Overall Conclusions Regarding Condition of the Bank: Examination Procedures

• Has the bank previously repurchased misplacement or other improper participations when a loss was handling of source data? incurred, although it was not legally • Are the bank’s computer hardware and required to do so? software systems inadequate to support the present and anticipated level of operations? Letters of Credit — Are deficiencies such that hardware and systems will require • Is there a trend toward increasing the replacement or upgrading in the issuance of standby letters of credit short term? or other similar credit instruments? — If so, has the bank failed to consider the full impact of funding a Settlement Procedures significant percentage of those instruments? • If the bank is a member of CHIPS, • Are letters of credit excluded from the Fedwire or other clearinghouse sys- bank’s internal loan review program? tem, are procedures inadequate for the • Does the internal evaluation of letters proper monitoring of incoming and of credit include consideration of coun- outgoing wire transfers so that the try and currency risk as well as credit bank is occasionally unprepared for risk? settlement? • Is there a declining trend in the credit — Would earnings be significantly quality of letters of credit? affected if the immediate acquisition of funds is required to meet • Are standby letters of credit issued for settlement? purposes not covered in the bank’s lending policy, or for which manage- — Is the bank aware of the creditwor- ment does not have the expertise to thiness and ability of the other handle? clearinghouse participants to make settlement? • If not authorized in the bank’s lending policy, were proper approvals obtained • Are customers’ daylight overdrafts prior to issuance? allowed to exceed established credit limits or are they otherwise being im- properly monitored? Wire Transfer Department • Is there a history of daylight overdrafts which have not been covered before • Do internal control deficiencies in the the close of business? wire transfer department pose a threat for large potential losses through fraud or error? Investment Securities • Are there internal control deficiencies in the receiving and conveying of mes- • Are there significant internal control sages for other parties which may deficiencies associated with the expose the bank to litigation for bank’s handling of ‘‘when issued’’ improper handling of the messages? trades, futures contracts and forward placements? Data Processing Department — Is management’s knowledge of interest rate hedging techniques • Are internal controls inadequate in the insufficient to support such bank’s data processing area? activity? — Are control deficiencies such that • Does the bank act as agent on the accuracy and/or timeliness of securities or repurchase agreement data is questionable? transactions? — Are deficiencies such that the bank, — If so, does the customer agreement in performing data processing ser- specifically designate liability for vices for others, could be liable for failure or performance?

March 1994 Commercial Bank Examination Manual Page 4 Overall Conclusions Regarding Condition of the Bank: Examination Procedures 5020.3

Miscellaneous — Abnormally low percentage of internal auditors to total personnel. • Did the analytical review of income — Inadequate training or supervision and expenses disclose any additional of internal auditors. off balance sheet activities for which — Questionable independence of management does not exhibit the nec- external auditors. essary expertise and does not have — Inadequate management response adequate internal controls to handle to deficiencies cited by auditors. the service? If so, do these or other pertinent fac- • Does a review of legal actions against tors indicate a less than adequate situ- the bank indicate any pattern of prac- ation in internal or external audit? tices which are caused by deficient • Are internal controls and audit pro- internal controls? grams deemed inadequate? — If so, have the deficiencies been corrected? • Is the potential liability arising from h. Ownership pending litigation considered signifi- • Have there been significant changes in cant in terms of capital adequacy and ownership since the last examination? liquidity, considering the level of other — If so, could the change be detri- contingent liabilities? mental to the soundness of the • Are any of the bank’s affiliates or bank? subsidiaries experiencing unprofitabil- • Does any situation exist wherein one ity or liquidity problems which may individual is capable of controlling the affect the soundness of the bank? bank? • Are operating lease liabilities and — If so, is that detrimental to the annual lease payments significant in bank’s soundness? terms of the bank’s other funding • Is there any evidence of an impending requirements? proxy fight? • Is potential restitution resulting from • Are ownership interests using bor- Truth in Lending Act violations signif- rowed funds to carry the bank’s stock? icant relative to capital and liquidity? — If so, is there an indication that • Is the bank’s level of loan commit- undue pressure for increased ments, standby letters of credit, com- earnings is being applied by the mitments to purchase securities and owners? futures/forward contracts imprudent in — If such pressure is being applied, light of overall circumstances within does that have a detrimental impact the bank? on the general characteristics of asset composition, as it exists, and asset composition, as it is expected g. Internal Controls and Audit to develop? Procedures

• Have internal controls deteriorated i. Miscellaneous since the last examination? • Do any of the following exist at the • Does the bank exhibit a high depen- bank? dence on purchasing or participating — Low compensation level of in loans originated and managed by internal auditors. others? — Internal or external auditor who — If so, is that attributable to a lack of reports directly to other than the local loan demand or to a failure of board of directors or a committee the bank to service its trade area? thereof. • Is there an increasing trend toward — Internal auditors who perform orig- making loans and/or accepting depos- inal work versus monitoring the its from outside of areas in which the efforts of others. bank maintains ofﬁces?

Commercial Bank Examination Manual March 1994 Page 5 5020.3 Overall Conclusions Regarding Condition of the Bank: Examination Procedures

— If so, does management and the b. Project the future condition of the bank board fully understand the risks based on its present financial condition, inherent in such activity? the economic expectations of the bank, • Has a trend toward increasing the quality of management, director advances to affiliated companies supervision and any other relevant developed? factors. — If so, does that presently represent c. Formulate recommendations for man- a dangerous situation? agement to consider when they initiate • Has the bank experienced an abnor- corrective or preventative action. mally fast rate of growth? 7. Conduct a final summary discussion with — If so, is that growth reasonable and management to include: does it therefore, have no signifi- a. Criticisms noted during the examination. cant impact on future soundness, b. Conclusions reached about the bank in based on: general. • Economic conditions within the c. Expected future condition: trade area? • Management’s view. • The bank’s increased marketing • Examiner’s view. efforts? d. Review of other potential problems. • Offering improved services to e. Planned corrective action: the community? • Examiner recommendations. • Other factors? • Management commitments. — If so, is the bank’s management 8. Update ‘‘Management Assessment’’ conclu- team capable of adequately admin- sion to add any relevant information istering the growth? obtained as a result of procedures per- • Does the bank have an imprudent formed in this program. investment in fixed assets? • Does the bank depend to an excessive 9. Prepare recommendations for any necessary degree on a small, local economy, supervisory action. which is subject to cyclical swings due 10. Perform the following steps for suspected to local conditions and industries, as violations of criminal statutes: opposed to mirroring national eco- a. Determine that a Criminal Referral Form, nomic trends? FR 2230, has been filed, if appropriate. — If so, is that a source of criticism or b. Notify the Reserve Bank by telephone does it represent a potentially dan- immediately if warranted by the type and gerous situation? seriousness of the suspected violation. • Are there large fluctuations in the stock c. Prepare a separate memorandum to the price of the bank or its parent? Reserve Bank containing sufficient detail — If so, is management unable to be fully informative. to discern a cause for such d. Prepare brief comments for the confiden- fluctuations? tial section of the report of examination • Is management giving inadequate citing the date of the memorandum to the attention to compliance with laws and Reserve Bank. regulations? e. Segregate, identify, initial and date all 4. Have all questions raised by the UBPR appropriate workpapers and transmit specialist been explored? them to the Reserve Bank making certain 5. Complete workpapers. that the workpapers are factual, com- 6. Organize general conclusions regarding the plete and do not contain expressions of present condition of the bank and: examiner opinion. a. Correlate plans, projections, forecasts, 11. Write, in appropriate report form, all com- and budgets with present conditional ments and conclusions to be included in the aspects, area characteristics, and manage- confidential section of the examination ment capability to determine which of report. the goals the bank has set you believe to 12. Update the workpapers with any informa- be unattainable. tion that will facilitate future examinations.

March 1994 Commercial Bank Examination Manual Page 6 Meetings with Board of Directors Effective date May 1995 Section 5030.1

INTRODUCTION tion needed by, or relevant to, the directorate. This information varies depending on the bank’s The board of directors plays an essential role in circumstances; however, examiners should inform the management of a bank’s operations and is the board of the examiner’s assessment of the directly responsible for the soundness of the bank’s condition; highlight any deficiencies bank. As a result, in some cases, it is useful for requiring the board’s attention; and solicit the Federal Reserve examiners and/or officers to board’s views on the bank’s condition, opera- meet with boards of directors. These meetings tions, and prospects. In addition, examiners provide examiners with the opportunity to inform should obtain the board’s commitment to address directors of examination findings, discuss the promptly the deficiencies identified in the exam- bank’s plans and prospects with the board, and ination. Examiners should encourage inquiries highlight important supervisory issues, particu- and discussions with the directors to learn more larly in cases that may require initiation of about the directors’ roles and performance and informal or formal supervisory actions. Meet- to foster a good working relationship with them. ings with boards of directors also provide exam- Data supporting the examiner’s conclusions iners with a limited opportunity to ascertain the and comments should be prepared and presented directors’ knowledge of and interest in the to board members in a professional manner. bank’s operations. Slides, handouts, and other visual aids are If Federal Reserve examiners believe it is encouraged. Comparative figures and ratios from necessary or desirable, they may conduct meet- previous and present examinations should be ings with directors immediately after the on-site reviewed prior to the meeting, with handouts portion of an examination and before an exami- and visual aids highlighting adverse trends. nation report is completed and distributed. Such meetings are particularly encouraged when they can be conducted as part of regularly scheduled board meetings that coincide with the on-site Outlines for Meetings examination. When a bank is determined to be a problem or Examiners should prepare detailed outlines of has exhibited significant deterioration, Federal each meeting’s discussion points and goals. Reserve examiners must conduct meetings with Following is a sample outline that examiners the directors. Such meetings require the partici- may use as a guide to prepare for meetings with pation of Federal Reserve officers and are typi- directors. It is not all-inclusive, and examiners cally conducted after the report of examination should not be limited by its content in devel- has been distributed. oping their own presentations. Generally, comments on these items are warranted when concerns have arisen during the current exami- GENERAL GUIDELINES nation, or when significant changes—positive or negative—have occurred since the last examination. Meetings with boards of directors must be tailored to the individual circumstances of each I. Introductory remarks by Federal Reserve bank, as well as to the Reserve Bank’s supervi- Bank official or examiner sory objectives. As a result, uniform procedures for the conduct of these meetings cannot be A. Federal Reserve Bank policy regarding specified. Nonetheless, the following guidelines board meeting should be considered when planning and con- B. Purpose of the meeting ducting meetings with bank directors. II. Examiner’s presentation A. Duties and responsibilities of directors 1. Effectively supervise the bank’s Content of Meetings affairs 2. Select competent management When participating in meetings with bank 3. Adopt and follow sound, written poli- boards, examiners should present only informa- cies and objectives

Commercial Bank Examination Manual May 1995 Page 1 5030.1 Meetings with Board of Directors

4. Avoid self-serving practices honorary directors to participate in discussions 5. Be informed of the bank’s financial and review the examination report is also condition and management policies permitted. 6. Maintain reasonable capitalization Generally, at least one member of a Reserve 7. Observe banking laws and regulations Bank’s official staff is expected to represent the B. Adequacy and effectiveness of policies Federal Reserve at meetings with directors of and procedures banks. However, for meetings with the directors 1. Lending of banks that have less than $500 million in 2. Investments assets, Reserve Banks are granted the discretion 3. Asset/liability management to have senior examination staff represent the 4. Personnel Reserve Bank. The participation of Reserve 5. Operations Bank presidents in meetings with directors is C. Adequacy and accuracy of bank’s left to the discretion of the Reserve Bank. reporting systems To the extent possible, meetings with the 1. Reports of the board and committees boards of directors of state member banks should 2. Management reports to the board include representatives of the relevant state 3. Management information systems banking authority. A meeting with the directors 4. Regulatory reports of a bank that is owned by a holding company D. Condition of the bank/results of the may be held at the same time as a meeting with examination the directors of the holding company, when 1. Asset quality appropriate. 2. Violations of law, evidence of self- Whenever a meeting is held between an dealing examiner and a board, the examiner should 3. Capital prepare written comments on the meeting for 4. Management examination workpapers. 5. Liquidity 6. Earnings MEETINGS WITH BOARDS OF 7. Internal controls and audit coverage PROBLEM BANKS AND BANKS 8. Future prospects 9. Relationships with bank holding EXHIBITING SIGNIFICANT company DETERIORATION E. Required corrective action on problems When an examination reveals that a bank has and board commitment significant problems, Federal Reserve policy III. Summary of overall conclusions requires that a meeting be held with its board of IV. Questions from the board directors. The policy further requires that a written summary of examination findings— separate from the complete examination Procedural Issues report—be distributed to each director in such cases. A senior Reserve Bank official also must In general, meetings with the full board are participate in communicating and presenting preferable. In certain cases, however, a Reserve examination findings on problem banks to their Bank may determine that meeting with a board boards of directors. This policy’s objective is to committee, such as the executive or audit com- ensure that each director of a state member bank mittee, will fulfill the Reserve Bank’s supervi- considered to be a problem or to have a signifi- sory objectives. Any person connected with the cant weakness clearly understands the nature bank, such as an attorney, auditor, or holding and dimension of the problems, as well as the company representative, may attend the board joint and several responsibility of the directors of directors meeting at which the overall find- to effect correction. ings and conclusions of the examination are discussed. The attendance of any such party should be noted in the minutes of the meeting. Criteria Requiring Meetings with However, the examiner may excuse such per- Problem Banks sons during any portion of his or her presentation if deemed appropriate. Attendance by A meeting with the board of directors is to be

May 1995 Commercial Bank Examination Manual Page 2 Meetings with Board of Directors 5030.1 held after any full-scope examination in which • inadequacies in policies, practices, and report- a state member bank is assigned a CAMELS ing systems necessary for proper risk manage- composite rating of 4 or 5. A meeting is also ment and organizational administration required if a bank is rated composite 3 and its • lack of well-documented lending, collection, condition appears to be deteriorating or has investment, asset/liability management, and shown little improvement since a previous risk-management policies or the failure to examination in which it received a composite ensure that such policies are being followed 3 rating. Furthermore, a meeting should be held • failure of management to address previously after a targeted examination if deemed appropri- discussed deficiencies ate and desirable by the Reserve Bank. An • lack of reporting systems sufficient to keep official of the Reserve Bank and the examiner- senior management and the board of directors in-charge should also meet with a board if any fully informed of the following conditions exist: • failure of the board of directors to ensure the active management of the organization • The bank is entering into a formal written agreement with the Federal Reserve, a cease- and-desist order is being issued, or the bank is being placed under a memorandum of MEETINGS WITH BOARDS OF understanding. MULTINATIONAL AND MAJOR • The bank is already operating under a super- REGIONAL BANKS visory action but is in noncompliance with significant provisions or has experienced sig- A meeting with the board of directors is required nificant deterioration since the action was after every full-scope examination of a multi- initiated. national organization or major regional organi- • Self-serving activities or other unsafe and zation with assets in excess of $5 billion. Reserve unsound practices exist in the bank. Banks also are encouraged to conduct such • Any other condition or practice that places, or meetings after every full-scope examination of a could place, the bank in a seriously weakened regional bank with assets in excess of $1 billion. or extended condition has been identified during the examination. MEETINGS WITH BOARDS OF DE NOVO BANKS Additional Guidelines After the approval of a membership application, but before a de novo bank is opened, Reserve Senior Reserve Bank officials are expected to Bank staff should meet with the full board of participate in meetings with the directors of directors to discuss applicable statutes, regula- problem banks, with the seniority of the partici- tions, policies, and supervisory procedures. As pating official determined by the condition and with all meetings with directors, the agenda for size of the bank. The larger the organization or this meeting should be tailored to the individual the more serious its problems, the more senior circumstances of the bank. At a minimum, the the Federal Reserve official should be. Reserve Bank should apprise the directors of A meeting with the board of directors of a their responsibilities and emphasize their need problem or deteriorating bank should include a to adhere to sound operating policies. formal, structured presentation with a clear statement that the bank is considered a ‘‘problem institution’’ or is about to become a problem institution if existing conditions deteriorate. The DIRECTOR’S SUMMARY OF presentation should further make clear the nature EXAMINATION FINDINGS of problems confronting the bank, citing examination findings such as the following: In addition to the report of examination, Federal Reserve Banks must provide written reports to • deficiencies in capital, asset quality, earnings, directors summarizing the examination findings or liquidity for all banks rated composite 3, 4, or 5, and for • violations of law those rated composite 1 or 2 that show signs of

Commercial Bank Examination Manual May 1997 Page 3 5030.1 Meetings with Board of Directors significant deterioration in condition or apparent should be similar, if not identical, to the text of violations of law. The summary reports should these report pages. focus on identified problems—rather than on the Summary reports should be sent directly to strength of the organization—and present the the bank’s management for distribution to each bank’s deficiencies succinctly and clearly. In all director. The transmittal letter to the bank should cases, the types of actions directors and man- state the report is a summary of identified agement should take to address identified prob- problems and contemplated supervisory actions lems should be specifically stated. Directors of and direct bank management to distribute the institutions rated 4 or 5 are to be told their banks summary report to each director. The letter are ‘‘problem’’ institutions that warrant ‘‘special should further instruct each director to read the supervisory attention.’’ Directors of banks rated report, sign the introductory statement attesting 3 are to be informed that the bank’s condition is to having read the report, and return the report to ‘‘not satisfactory,’’ that the bank is subject to management. Management should keep copies ‘‘more-than-normal supervision,’’ and that the of the directors’ signed statements on file, but bank may become a ‘‘problem’’ if weaknesses should destroy all but one file copy of the are not addressed adequately. summary report itself. Summary reports should emphasize the The summary report must be completed and responsibilities of the directors to ensure that distributed before any meeting between Reserve corrective actions are taken to address all defi- Bank officials and the bank’s board of directors, ciencies noted in the pages of the full bank to provide the directors with prior notice of examination report entitled ‘‘Matters Requiring deficiencies to be discussed. Reserve Banks Board Attention’’ and ‘‘Examination Conclu- should also make every effort to distribute the sions and Comments.’’ In addition, the organi- complete examination report to management zation, style, and content of the summary report before meeting with a board of directors.

May 1997 Commercial Bank Examination Manual Page 4 Meetings with Board of Directors Examination Objectives Effective date March 1984 Section 5030.2

1. To foster a better understanding of the may have signiﬁcant impact on the future respective roles of directors and examiners. condition of the bank. 2. To inform the directors of the examination 4. To reach an agreement on any signiﬁcant scope and the bank’s condition. problems. 3. To obtain information concerning future plans 5. To obtain a commitment to initiate appropri- and proposed changes in bank policies that ate corrective action.

Commercial Bank Examination Manual March 1994 Page 1 Meetings with Board of Directors Examination Procedures Effective date March 1984 Section 5030.3

1. Inform management that a meeting will be 7. For ‘‘special meetings’’ resulting from ser- held with the board of directors. State the ious problems: Federal Reserve Bank’s policy and the pur- a. Communicate with the Reserve Bank to: pose of the meeting and establish a tentative • Notify office staff of the proposed date date. and place of the meeting. 2. Finalize the time and place of the meeting • Determine whether a Reserve Bank when confident that a thorough understand- official will attend. ing of the condition of the bank will be • Determine whether the Reserve Bank developed. If the meeting is to be a ‘‘special official has suggestions for the agenda. meeting’’ resulting from serious areas of b. Confirm the final time and place of the concern, perform procedure 7. meeting with the Reserve Bank office. 3. Develop an outline of matters to be covered c. Prepare any special supporting data for at the meeting by reviewing results of the the meeting, such as areas of noncompli- examination. ance with memorandums of understand- 4. Prepare supportive data for the meeting by: ing or cease and desist agreements or a. Compiling a list of comments and orders. criticisms. 8. Conduct the board meeting in accordance b. Preparing schedules of comparative fig- with the agenda and previously prepared ures for discussion. outline, being certain to discuss: c. Affirming that the bank has responded a. Major criticisms noted during the adequately to Reserve Bank requests. examination. d. Preparing questions to elicit opinions b. Conclusions reached about the bank in and attitudes of individual board general. members. c. Expected future conditions. 5. Prepare a brief formal agenda for the meet- d. Potential problems. ing and reproduce enough copies to distrib- e. Planned corrective action: ute to participants. • Examiner’s recommendations. 6. If it is decided that a meeting will be held: • Management’s commitments. a. Communicate with Reserve Bank office to: • Director’s commitments. • Notify office staff of the proposed date 9. Obtain a definite agreement or commitment and place of the meeting. (Confirm from the board that appropriate corrective time and place when final.) action will be taken. • Determine whether a Reserve Bank 10. Prepare a memorandum covering the meet- official will attend. ing with the board to include, as a minimum: • Determine whether the Reserve Bank a. The time and place of the meeting. official has suggestions for the agenda. b. The directors and guests in attendance. b. Submit a copy of the agenda and outline c. The matters subject to criticism that were in advance to the Reserve Bank official. reviewed. c. Inform directors that the following must d. A summary of the general discussion on be submitted to the Reserve Bank office: the matters presented to the board. • A copy of a board resolution stating e. A summary of the director’s reaction to corrective action. the situation and any commitments • A written plan for corrective action to obtained from them. be forwarded within a specified time 11. Request that copies of the minutes of the period. board meeting be forwarded to the Reserve • Periodic progress reports. Bank and the examiner-in-charge.

Commercial Bank Examination Manual March 1994 Page 1 Formal and Informal Corrective Actions Effective date November 2003 Section 5040.1

INTRODUCTION remove from office and of prohibition) is served on the party before the end of a six-year period. The Federal Reserve Board has a broad range of enforcement powers over both domestic and foreign financial institutions and over the indi- FORMAL SUPERVISORY viduals associated with them. Generally, formal ACTIONS or informal enforcement actions are taken after the completion of an on-site bank examination. The following statutory tools are available to These examinations include commercial, trust, the Board in the event formal supervisory action electronic data processing, consumer, or other is warranted against a state member bank or types of examinations. Formal or informal any institution-affiliated party. The objective of enforcement actions may also be taken when a formal action is to correct practices that the Reserve Bank becomes aware of a problem at a regulators believe to be unlawful, unsafe, or bank that warrants immediate attention and unsound.3 The initial consideration and determi- correction. nation of whether formal action is required Many of the Board’s enforcement powers usually results from examination findings. It is were initiated or enhanced by title IX of the important to provide adequate workpaper docu- Financial Institutions Reform, Recovery, and mentation to support all recommendations for Enforcement Act (FIRREA) and by the Com- both formal and informal actions. prehensive Thrift and Bank Fraud Act (Bank Fraud Act).1 The Board’s jurisdiction over individuals associated with financial institutions, that is, ‘‘institution-affiliated parties,’’ includes Types of Corrective Actions any officer, director, employee, controlling shareholder, or agent of a financial institution, and Generally, under 12 USC 1818, the Board may any other person who has filed or is required to use its cease-and-desist authority and civil money file a change-in-control notice. The term penalty authority against any state member bank ‘‘institution-affiliated party’’ also includes any and any institution-affiliated party that meets the shareholder, consultant, joint venture partner, or statutory criteria for issuing such an order. any other person who participates in the conduct Prohibition and removal actions may be taken of the affairs of the financial institution, as well against any institution-affiliated party who meets as any independent contractors, including attor- the statutory criteria to bring such an action. neys, appraisers, and accountants, who knowingly or recklessly participate in any violation of law or regulation, breach of fiduciary duty, or Cease-and-Desist Orders unsafe or unsound practice that causes (or is likely to cause) more than a minimal financial Generally, under 12 USC 1818(b), the Board loss to, or a significant adverse effect on, a may use its cease-and-desist authority against a financial institution.2 The Board’s jurisdiction state member bank and any institution-affiliated over an institution-affiliated party extends for up party when it finds that a bank or party is to six years after the party’s resignation, termi- engaging, has engaged, or is about to engage in nation of employment, or separation caused by (1) a violation of law, rule, or regulation; (2) a the closing of a financial institution, provided violation of a condition imposed in writing by that any notice (such as a notice of intent to the Board in connection with the granting of any application or any written agreement; or (3) an unsafe or unsound practice in conducting the 1. The Financial Institutions Reform, Recovery, and business of the institution. Under 12 USC Enforcement Act was enacted on August 9, 1989; the Com- prehensive Thrift and Bank Fraud Act was enacted on November 27, 1990. 3. An unsafe or unsound practice is defined as any action 2. The Board is authorized to issue regulations further that is contrary to generally accepted standards of prudent defining which individuals should be considered institution- operation, the possible consequences of which, if continued, affiliated parties. Similarly, the Board may determine whether would be abnormal risk or loss or damage to an institution, its an individual is an institution-affiliated party on a case-by- shareholders, or the agencies administering the insurance case basis. (See 12 USC 1813(u).) fund.

Commercial Bank Examination Manual November 2003 Page 1 5040.1 Formal and Informal Corrective Actions

1818(s), the Board must initiate a cease-and- ing4 conducted before an administrative law desist action against a bank when it has failed to judge, appointed by the Board. After the hear- establish Bank Secrecy Act procedures required ing, the judge makes a recommended decision to by the Board’s Regulation H or has failed to the Board. A hearing must be held within 30 to correct any previously noted deficiencies related 60 days of service of the notice of charges, to these procedures. unless a later date is set by the administrative A cease-and-desist order may require the law judge. After the Board considers the record bank or person subject to the order to (1) cease of the proceeding, including the administrative and desist from the practices or violations or law judge’s recommended decision, it deter- (2) take affirmative action to correct the viola- mines whether to issue a final cease-and-desist tions or practices. Affirmative actions might order. Banks and individuals who are subject to include returning the bank to its ‘‘original con- cease-and-desist orders that were issued as a dition’’ before the practice or violation. Affir- result of contested proceedings may appeal the mative actions may also include restrictions order to the appropriate federal court of appeals. on growth, debt, and dividends; the disposition of any loan or asset; rescission of agreements or contracts; employment of qualified officers or Temporary Cease-and-Desist Orders employees; restitution, reimbursement, indemnification, or guarantee against loss if the bank If a violation or threatened violation of law, rule, or person was unjustly enriched by the violation or regulation, or if engagement in an unsafe or or practice, or if the violation or practice unsound practice specified in the notice of involved a reckless disregard for the law or charges, is likely to cause the bank’s insolvency, applicable regulations or a prior order; and cause significant dissipation of the bank’s assets any other action the Board determines to be or earnings, weaken the bank’s condition, or appropriate. otherwise prejudice the interests of depositors When Board staff, in conjunction with the before the completion of the proceedings (initi- appropriate Reserve Bank, determine that a ated by the issuance of the notice of charges), cease-and-desist action is necessary, the bank or the Board may, in conjunction with issuing a person is generally given an opportunity to notice of charges, issue a temporary cease-and- consent to the issuance of a cease-and-desist desist order against the bank or any institution- order without the need for the issuance of a affiliated party to effect immediate correction notice of charges and a contested administrative (pursuant to 12 USC 1818(c)). The Board may hearing. Generally, Board staff draft a proposed also issue a temporary order if it determines that cease-and-desist order and, with Reserve Bank the bank’s books and records are so incomplete staff, present it to the bank or individual for or inaccurate that the Board is unable to deter- consent before submitting the case to the Board. mine, through the normal supervisory process, Banks or individuals are advised that they may the bank’s financial condition or the details or have legal counsel present at all meetings with purpose of any transaction that may have a Board or Reserve Bank staff concerning formal material effect on its condition. The temporary corrective actions. If the parties voluntarily order may require the same corrections as a agree to settle the case by the issuance of a formal cease-and-desist order. The advantage of consent cease-and-desist order, the proposed issuing a temporary cease-and-desist order is consent order will be presented to Board offi- that it becomes effective immediately after it is cials for ratification and formal issuance of the served on the entity or individual. Within 10 order, at which time the order will be final and days after being served with a temporary order, binding. however, the entity or individual may appeal to When a bank or person fails to consent to a a U.S. district court for relief from the order. cease-and-desist order, the Board may issue a Unless set aside by the district court, the tem- notice of charges and of hearing to the bank or porary order stays in effect until the Board party. The notice of charges contains a detailed issues a final cease-and-desist order or dismisses statement describing the facts constituting the the action. alleged violations or unsafe or unsound practices. The issuance of the notice of charges and 4. A private hearing may be held if the Board determines of hearing starts a formal process that includes that holding a public hearing would be contrary to the public the convening of a public administrative hear- interest.

November 2003 Commercial Bank Examination Manual Page 2 Formal and Informal Corrective Actions 5040.1

Written Agreements — demonstrates a willful or continuing disregard for the safety or soundness of the When circumstances warrant a less severe form institution. of formal supervisory action, a written agreement may be used. A written agreement may The statute also authorizes the Board to ini- be with either the Board or with the Reserve tiate removal or prohibition actions against Bank under delegated authority (12 CFR (1) any institution-affiliated party who has com- 265.11(a)(15)). All written agreements must be mitted a violation of any provision of the Bank approved by the Board’s director of the Division Secrecy Act that was not inadvertent or uninten- of Banking Supervision and Regulation and the tional, (2) any officer or director of a bank who general counsel. The provisions of a written has knowledge that an institution-affiliated party agreement may relate to any of the problems has violated the money-laundering statutes and found at the bank or to any problems involving did not take appropriate action to stop or prevent institution-affiliated parties. the reoccurrence of such a violation, or (3) any officer or director of a bank who violates the prohibitions on management interlocks. These Prohibition and Removal Authority removal or prohibition actions do not require a finding of gain to the individual, loss to the The Board is authorized by 12 USC 1818(e) to institution, personal dishonesty, or willful or remove any current institution-affiliated party of continuing disregard for the safety or soundness a bank for certain violations and misconduct and of the institution.6 Like a cease-and-desist order, to prohibit permanently from the banking indus- a removal or prohibition order may be issued try any current or former institution-affiliated either by consent or after an administrative party from future involvement with any insured process initiated by the issuance of a notice of depository institution, bank or thrift holding intent to remove and prohibit. company, and nonbank subsidiary.5 If an institution-affiliated party’s actions war- The Board is authorized to initiate removal or rant immediate removal from a state member prohibition actions when— bank, the Board is authorized to suspend the person temporarily from that bank pending the ¥ the institution-affiliated party has directly or outcome of the complete administrative process. indirectly— An institution-affiliated party presently associ- — violated any law, regulation, cease-and- ated with a bank may also be suspended or desist order, condition imposed in writing, removed for cause based on actions taken while or written agreement; formerly associated with a different insured — engaged in any unsafe or unsound prac- depository institution, bank holding company, or tice; or ‘‘business institution.’’ Business institution is — breached a fiduciary duty; not specifically defined in the statute so that it ¥ the Board determines that, because of the may be interpreted to include any other business violation, unsafe or unsound practice, or interests of the institution-affiliated party. breach— Under 12 USC 1818(g), the Board is autho- — the institution has suffered or will prob- rized to suspend from office or prohibit from ably suffer financial loss or other damage; further participation any institution-affiliated — the interests of depositors have been or party charged or indicted for the commission of could be prejudiced by the violation, prac- a crime involving personal dishonesty or breach tice, or breach; or of trust that is punishable by imprisonment for a — the institution-affiliated party has received term exceeding one year under state or federal financial gain or other benefit from the law, if the continued participation might threaten violation, practice, or breach; and either the interests of depositors or public con- ¥ the violation, practice, or breach— fidence in the bank. The Board may also sus- — involves personal dishonesty or pend or prohibit any individual charged with a violation of the money-laundering statutes. The suspension can remain in effect until the criminal action is disposed of or until the suspension 5. This authority is distinct from the Board’s authority under prompt corrective action to dismiss senior officers from a particular bank. 6. See 12 USC 1818(e)(2).

Commercial Bank Examination Manual November 2002 Page 3 5040.1 Formal and Informal Corrective Actions is terminated by the Board. The Board may also institution-affiliated party for any violation of initiate a removal or prohibition action against (1) law or regulation; (2) a final cease-and- an institution-affiliated party who has been con- desist, temporary cease-and-desist, suspension, victed of, or pleaded to, a crime involving removal, or prohibition order or for failure to personal dishonesty or breach of trust if his or comply with a prompt-corrective-action- her continued service would threaten the inter- directive;7 (3) a condition imposed in writing by ests of the depositor or impair public confidence the Board in connection with the granting of an in the institution. The Board is required to issue application or other request; and (4) a written such an order against any institution-affiliated agreement. party who has been convicted of, or pleaded to, A fine of up to $25,000 per day can be a violation of the money-laundering statutes. assessed for a violation, an unsafe or unsound Furthermore, 12 USC 1829 prohibits any practice recklessly engaged in, or a breach of individual who has been convicted of a crime fiduciary duty when the violation, practice, or involving dishonesty, breach of trust, or money breach is part of a pattern of misconduct, causes laundering from (1) serving as an institution- or is likely to cause more than a minimal loss to affiliated party of, (2) directly or indirectly the bank, or results in pecuniary gain or other participating in the affairs of, and (3) owning or benefit for the offender. A civil money penalty controlling, directly or indirectly, an insured of up to $1 million per day can be assessed for depository institution without the FDIC’s prior any knowing violation, unsafe or unsound prac- approval. Under certain circumstances, the stat- tice, or breach of any fiduciary duty when the ute also prohibits a convicted person from hold- offender knowingly or recklessly caused a sub- ing a position at a bank holding company or stantial loss to the financial institution or received nonbank affiliate of a bank without the FDIC’s a substantial pecuniary gain or other benefit. prior approval. The penalty for violation of this Civil money penalties may also be assessed, law is a potential fine for a knowing violation of under the three-tier penalty framework described up to $1 million per day, imprisonment for up to above, for any violation of the Change in Bank five years, or both. The criminal penalty applies Control Act and for violations of the anti-tying to both the individual and the employing provisions of federal banking law, among other institution. provisions.8 The Board may also assess civil money penalties for the submission of any late, false, or Violations of Final Orders and misleading call reports. If a financial institution Written Agreements maintains procedures that are reasonably adapted to avoid inadvertent errors, but unintentionally When any final order or temporary cease-and- fails to publish any report, submits any false or desist order has been violated, the Board may misleading report or information, or is mini- apply to a U.S. district court for enforcement of mally late with the report, it can be assessed a the action. The court may order and require fine of up to $2,000 per day. The financial compliance. institution has the burden of proving that the Violations of final orders and written agree- error was inadvertent under these circum- ments may also give rise to the assessment of stances. If the error was not inadvertent or the civil money penalties against the offending bank bank lacked the appropriate procedures, a pen- or institution-affiliated party, as circumstances alty of up to $20,000 per day can be assessed for warrant. The civil money penalty is assessed in all false or misleading reports or information the same manner as described in the ‘‘Civil submitted to the Board. If the submission was Money Penalties’’ subsection below. Any institution-affiliated party who violates a suspen- 7. Prompt-corrective-action directives may be enforced in sion or removal order is subject to a criminal the federal courts, and they may cause any bank, company, or fine of up to $1 million, imprisonment for up to bank-affiliated party that violates the directive to be subject to five years, or both. civil money penalties. The failure of a bank to implement a capital-restoration plan, or the failure of a company having control of a state member bank to fulfill a guarantee that the Civil Money Penalties company has given in connection with a capital plan accepted by the Federal Reserve, could subject the bank or company or any of their bank-affiliated parties to a civil money penalty The Board may assess civil money penalties of assessment. (See section 4133.1.) up to $5,000 per day against any institution or 8. See 12 USC 1972.

November 2002 Commercial Bank Examination Manual Page 4 Formal and Informal Corrective Actions 5040.1 done in a knowing manner or with reckless mum capital standards must provide 30 days’ disregard for the law, a fine of up to $1 million written notice to the Board of Governors before or 1 percent of the institution’s assets, which- appointing any new director or senior executive ever is less, can be assessed for each day of the officer.10 This requirement also applies to any violation. Under its general civil money penalty change in the responsibilities of any current authority, the Board may also assess civil money senior executive officer who is proposing to penalties against any institution-affiliated party assume a different senior officer position. Sub- who participates in a bank’s filing of late, false, part H of Regulation Y details the procedures or misleading call reports. for filing and the content of the notice. The Board may disapprove a notice if it finds that the competence, experience, character, or integrity Administration of Formal Actions of the proposed individual indicates that his or her service would not be in the best interest of Publication of Final Orders the institution’s depositors or the public. A disapproved individual or the institution that Under 12 USC 1818(u), the Board is required to filed the notice may appeal the Federal Reserve’s publish and make publicly available any final notice of disapproval under the procedures order issued for any administrative enforcement detailed in Regulation Y. The individual may not proceeding it initiates. These orders include serve as a director or senior executive officer cease-and-desist, removal, prohibition, and civil while the appeal is pending. In the event that a money penalties. The Board is also required to state member bank or bank holding company publish and make publicly available any written that is in a troubled condition appoints a director agreement or other written statement that it may or senior officer without the required 30 days’ enforce, unless the Board determines that pub- prior written notice, appropriate follow-up lication would be contrary to the public interest. supervisory action should be taken.

Public Hearings Interagency Notiﬁcation

Under 12 USC 1818(u), all formal hearings, Under interagency agreements, any federal bank- including contested cease-and-desist, removal, ing regulatory agency that proposes to take a and civil money penalty proceedings, are open formal enforcement action (such as a cease-and- to the public unless the Board determines that a desist order, civil money penalty, or removal) public hearing would be contrary to the public must notify the other federal financial institution interest. Transcripts of all testimony; copies of regulatory agencies (including the OTS) of the all documents submitted as evidence in the action. For informal enforcement actions, such hearing, which could include examination or as memoranda of understanding, notifications inspection reports and supporting documents must be made when there is an affiliation or (except those filed under seal); and all other interinstitution relationship. Notifications are to documents, such as the notice and the adminis- be made to a designated contact person specified trative law judge’s recommended decision, are by each agency. To foster federalÐstate agency available to the public. coordination, the Federal Reserve provides the appropriate state supervisory authority with Appointment of Directors and Senior Executive Officers condition if it (1) has a composite rating, determined at its most recent examination, of 4 or 5; (2) is subject to a cease-and-desist order or formal written agreement that Under section 32 of the Federal Deposit Insur- requires action to improve the bank’s financial condition; or ance Act (12 USC 1831i) and subpart H of (3) is expressly informed by the Board or Reserve Bank that Regulation Y (12 CFR 225.71 et seq.), any state it is in troubled condition. 10. The Board or Reserve Bank may permit, under extraor- member bank or bank holding company that is dinary circumstances, an individual to serve as a director or in a troubled condition9 or does not meet mini- senior executive officer before a notice is provided; however, this permission does not affect the Federal Reserve’s authority to disapprove a notice within 30 days of its filing. The Board 9. As defined in section 225.71 of the Board’s Regulation may extend the review period to a maximum of 90 days if Y, a state menber bank or holding company is in troubled needed to process the notice.

Commercial Bank Examination Manual November 2003 Page 5 5040.1 Formal and Informal Corrective Actions notice of its intent to institute a formal correc- agement. Although an informal action, impo- tive action against a bank or its institution- sition of an MOU may require disclosure to afﬁliated parties, pursuant to 12 USC 1818(m).11 the Securities and Exchange Commission and to the bank’s liability bond issuer.

INFORMAL SUPERVISORY ACTIONS INDEMNIFICATION PAYMENTS Informal supervisory tools are used when cir- AND GOLDEN PARACHUTE cumstances warrant a less severe form of action PAYMENTS than the formal supervisory actions described above. Informal actions are not enforceable, and In general, an indemnification payment is a their violation cannot serve as a basis for assess- payment that reimburses an insider for a speci- ing a civil money penalty or initiating a removal fied liability or cost that the person incurred (for and prohibition action. Informal actions are not example, a bank might indemnify a director for published or publicly available. These informal the cost of legal fees or even, theoretically, actions include the following: penalties in connection with a Federal Reserve investigation or enforcement action). Golden ¥ Commitments are generally used to correct parachute payments are severance payments or minor problems or to request periodic reports agreements to make severance payments that are addressing certain aspects of a bank’s opera- paid or entered into at a time when the bank or tions. Commitments may be used when there holding company is in a troubled condition. are no significant violations of law or unsafe These payments require the prior written approval or unsound practices and when the bank and of the institution’s primary regulator and the its officers and directors are expected to FDIC. A golden parachute payment may include cooperate and comply.12 Commitments are a glorified severance payment to a former insider generally obtained by the Reserve Bank’s that is paid under specified circumstances. sending a letter to the bank outlining the Although both types of payments fall under the request and asking for a response and an same statute, section 18(k) of the Federal Deposit indication that the commitments are accepted. Insurance Act (the FDI Act) (12 USC 1828(k)), the two types of payments are quite different and ¥ Board resolutions generally represent a num- distinct. However, some of the restrictions on ber of commitments made by the bank’s these payments are the same or similar. directors and are incorporated into the bank’s corporate minutes. The Reserve Bank may request board resolutions in the examination transmittal letter, which asks the bank to Indemnification Agreements and provide it with a signed copy of the corporate Payments resolution. State member banks may seek to indemnify ¥ Memoranda of understanding (MOU) their officers, directors, and employees from any are highly structured written, but informal, judgments, fines, claims, or settlements, whether agreements that are signed by both the Reserve civil, criminal, or administrative. The bylaws of Bank and the bank’s board of directors. An some state member banks may have broadly MOU is generally used when a bank has worded indemnification provisions, or the bank multiple deficiencies that the Reserve Bank may have entered into separate indemnification believes can be corrected by the present man- agreements that cover the ongoing activities of its own institution-affiliated parties. Such indem- 11. The procedures for notification to state agencies and nification provisions may be inconsistent with other federal banking regulatory agencies are outlined in SR-97-5, ‘‘Policy Statement on Interagency Notification and federal banking law and regulations, as well as Coordination of Enforcement Action.’’ with safe and sound banking practices. 12. Informal commitments are distinct from conditions Supervisory and examiner staff should be imposed in writing in connection with the grant of an application or other request by an institution, which may be alert to the limitations and prohibitions on enforced through the imposition of a civil money penalty. indemnification imposed by section 18(k) of the

November 2003 Commercial Bank Examination Manual Page 6 Formal and Informal Corrective Actions 5040.1

FDI Act13 and the regulations issued thereunder follow-up supervisory action may be taken. As by the FDIC. The law and regulations apply to part of the supervisory process, which will indemnification agreements and payments made include merger and acquistion applications, the by any bank to any institution-affiliated party, Federal Reserve’s supervisory and examiner regardless of the condition of the financial staff will review identified agreements having institution. The purpose of the law and regula- indemnification-related issues for compliance tions is to preserve the deterrent effects of with federal law and regulations. (See SR-02- administrative enforcement actions (by ensuring 17.) that individuals subject to final enforcement actions bear the costs of any judgments, fines, and associated legal expenses) and to safeguard Golden Parachute Payments the assets of financial institutions. A prohibited indemnification payment includes ‘‘Golden parachute’’ payment restrictions were any payment (or agreement to make a payment) enacted as part of the Crime Control Act of by a bank to an institution-affiliated party to pay 1990.15 The law added section 18(k) to the or reimburse such person for any liability or Federal Deposit Insurance Act (12 USC 1828(k)) legal expense in any federal banking agency and authorized the FDIC to issue implementing administrative proceeding that results in a final regulations. The FDIC’s golden parachute regu- order or settlement in which the institution- lations may apply to an insured depository affiliated party is assessed a civil money penalty, institution if the institution is in a troubled is removed or prohibited from banking, or is condition as defined in Regulation Y. The pur- required to cease an action or take any affirma- poses of the law and regulations include safe- tive action, including making restitution, with guarding the assets of financial institutions and respect to the bank.14 In cases in which the limiting rewards to institution-affiliated parties institution-afilliated party prevails, the institu- who may have contributed to the institution’s tion can make a payment if the board of direc- condition. tors determines that it is in the best interest of In general, the FDIC’s regulations prohibit the institution and the payment does not mate- insured depository institutions and their holding rially adversely affect the institution’s safety and companies from making golden parachute pay- soundness. ments except in certain circumstances.16 A The law and the FDIC’s regulations apply to golden parachute payment means any payment all state member banks. They reinforce the in the nature of compensation (or agreement to Federal Reserve’s longstanding policy that an make such a payment) for the benefitofany institution-affiliated party who engages in mis- current or former institution-affiliated party of conduct should not be insulated from the con- an insured depository institution or its holding sequences of his or her misconduct. From a company that meets three criteria. First, the safety-and-soundness perspective, a state mem- payment or agreement must be contingent on the ber bank should not divert its assets to pay a fine termination of the institution-affiliated party’s or other final judgment issued against an employment or association. Second, the pay- institution-affiliated party for misconduct that ment or agreement is received on or after, or presumably violates the bank’s policy of com- made in contemplation of, among other things, a pliance with applicable law, especially in cases determination that the institution or holding where the individual’s misconduct has already company is in a troubled condition under the harmed the bank. regulations of the applicable banking agency. State member banks should review their Third, the payment or agreement must be pay- bylaws and any outstanding indemnification able to an institution-affiliated party who is agreements, as well as insurance policies, to terminated when the institution or holding com- ensure that they conform with the requirements pany meets certain specific conditions, includ- of federal law and regulations. If a state member ing being subject to a determination that it is in bank fails to take appropriate action to bring its a troubled condition. indemnification provisions into compliance with federal laws and regulations, appropriate 15. SR-90-38 generally describes the provisions of the Crime Control Act of 1990. 13. See 12 USC 1828(k). 16. See the FDIC’s golden parachute regulations in 12 14. See 12 CFR 359. CFR 359.

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The definition of a golden parachute payment be contrary to the purposes of the statute or also covers a payment made by a bank holding regulations. company that is not in a troubled condition to an A state member bank or bank holding com- institution-affiliated party of an insured deposi- pany requesting approval to make a golden tory institution subsidiary that is in a troubled parachute payment or enter into an agreement to condition, if the other criteria in the definition make such a payment should submit its request are met. This circumstance may arise when a simultaneously to the appropriate FDIC regional bank holding company, as part of an agreement office and Federal Reserve Bank. The request to acquire a troubled bank or savings associa- must detail the proposed payments and demon- tion, proposes to make payments to the troubled strate that the state member bank or bank institution’s institution-affiliated parties that holding company does not possess and is not are conditioned on their termination of aware of any evidence that there is reasonable employment.17 basis to believe, at the time that the payment is A state member bank or bank holding com- proposed to be made, that the institution- pany may make or enter into an agreement to affiliated party receiving such a payment has make a golden parachute payment only (1) if the committed any fraud, breach of fiduciary duty, Federal Reserve, with the written concurrence of or insider abuse or has materially violated any the FDIC, determines that the payment or agree- applicable banking law or regulation that had or ment is permissible; (2) as part of an agreement is likely to have a material adverse effect on the to hire competent management in certain condi- bank or company; that the individual is substan- tions, with the consent of the Federal Reserve tially responsible for the institution’s insolvency and the FDIC as to the amount and terms of the or troubled condition; and that the individual has proposed payment; or (3) pursuant to an agree- violated specified banking or criminal laws. ment to provide a reasonable severance not to If a state member bank or bank holding exceed 12 months’ salary in the event of an company makes or enters into an agreement to unassisted change in control of the depository make a golden parachute payment without prior institution, with the consent of the Federal regulatory approval when such an approval is Reserve. In determining the permissibility of the required, appropriate follow-up supervisory payment, the Federal Reserve may consider a action should be taken. This follow-up could variety of factors, including the individual’s include an enforcement action requiring the degree of managerial responsibilities and length offending institution-affiliated party to reim- of service, the reasonableness of the payment, burse the institution for the amount of the and any other factors or circumstances that prohibited payment. When state member banks would indicate that the proposed payment would or bank holding companies are identified as having golden parachuteÐrelated issues in the 17. The FDIC’s regulations exclude from the definition of supervisory process, those issues should be a golden parachute payment several types of payments, such carefully reviewed for compliance with the law as payments made pursuant to a qualified pension or retire- ment plan; a benefit plan or bona fide deferred compensation and the FDIC’s regulations. The appropriate plan (which are further defined in the FDIC’s regulations); or Reserve Bank supervisory staff and the appro- a severance plan that provides benefits to all eligible employ- priate staff of the Board’s Division of Banking ees, does not exceed the base compensation paid over the Supervision and Regulation should be notified preceding 12 months, and otherwise meets the regulatory definition of nondiscriminatory and other conditions in the and consulted on the golden parachuteÐrelated FDIC’s regulations. issues. (See SR-03-06.)

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